Tuesday, January 14, 2014

I Was Wrong, But In A Good Way...

From the Desk of Joe Rollins

I’m sure by now some of you are laughing at my erroneous forecast of a low double digit gain for 2013 in the broad stock market. Due to the fact that the S&P was up 32.39% for 2013, I guess I have to admit that I missed my projection for that year by a full 20 percentage points. While it was certainly an inaccurate forecast, I have no regrets as it was quite a spectacular year.

I will give you my projections for 2014 later in the post, but for now let’s not diminish what a great financial year 2013 was. Although almost predicted by none, including myself, this was the best stock market since 1997. When there is this type of growth in financial assets with virtually no inflation in the economy, you truly build wealth for those that are invested. Unfortunately, so many clients who I speak with daily are grossly under-invested and completely missed this opportunity for true wealth generation in 2013.

In summary, the year 2013 ended quite nicely. For the month of December, the Standard & Poor’s index of 500 stocks was up 2.5% and as previously mentioned, was up 32.39% for all of 2013. The Dow Jones Industrial Average was up 3.2% in December and up 29.7% for 2013. The NASDAQ Composite added 3% during December and was up a sterling 40.1% for all of 2013. Even the Russell 2000 small-cap stocks were up 1.9% in December and up quite an impressive 38.8% for all of 2013. Unfortunately, the same cannot be said for bonds. If you used an aggregate bond return for all of 2013, the Barclays Aggregate Bond Index was down again in December and ended the year with a negative rate of return of 2.4%. Therefore, it can clearly be said that 2013 was a sterling year for stock performance, but truly an awful year for those invested in bonds.

While it is too early to tell exactly what the final GDP numbers will be for 2013, I am under the assumption that the year will close out at roughly 2.5% growth for all of 2013. While this is certainly not extraordinary, at least it is a solid growth based on several sub-par years of GDP growth. I believe 2014 could be the year that our GDP actually picks up. I do not expect a runaway increase in the GDP rate, but I do believe it is perfectly possible that 2014 could see an average of 3%, if not a little higher. I think the odds of being slightly higher are even greater than it ending below 3%.

The financial community was disappointed in the number of jobs created during December of 2013. After these sub-standard numbers were announced last Friday, the market sold off and the usual dire predictions came out regarding employment. However, I think people are not thinking through these numbers realistically. There has rarely been a December on record in which the weather has been as poor as it was last month. With the severe cold weather endured during the holiday season, there were many businesses that just could not operate. For example, in most of the northeast, virtually every construction industry position was brought to a standstill due to the severe cold weather. The way people tend to just react and not think through these numbers is something I will never understand. I project that we will see an upward revision for December in later periods and will return to a normal job creation month beginning in February, as the weather improves.

2013 will also be known as the year housing finally picked up again. For the first time since 2007, housing prices moved up smartly, even in a low inflation environment. With all of the new construction occurring throughout most of the United States, we are already seeing hot real estate markets with more buyers than sellers. Although home prices went up dramatically in 2013, I fully anticipate the prices will continue to drift higher in 2014 by at least 5%. There has been a fairly remarkable increase in price given the low inflation. If ever we should have a high inflation cycle, home prices would most likely increase at a rate near double digits. As I have written many times over the last five years, the housing market is one driven by supply and demand. For many years, even with low interest rates, people were afraid to purchase homes and therefore prices trended downward. Once confidence levels increased in 2012 and 2013, the demand for houses began to far exceed the number of houses already built. Builders are now quickly putting up housing spanning all price ranges. Due to so many years of inactivity, it would not surprise me to see the demand for new houses exceeding the supply for a couple more years.

I must be honest; I do not have a good feeling about bonds and CDs going into 2014. The Federal Reserve has already announced that they are tapering their bond purchase program in January of 2014. While mainly symbolic, it does have a sort of psychologically negative effect on interest rates. We have always known that the Federal Reserve can only control short-term interest rates, not long-term rates. But once short-term rates start rising, it is likely that long-term rates will also rise. We began the year 2013 with a 10-year Treasury note earning 1.71% and ended the year with it at almost 3%. If you were not keeping up with that trend, the effect of higher interest rates diminished the value of your bond portfolio. And as the Barclays Aggregate Bond Index reflects, there is a high likelihood if you owned any bonds at all during 2013 you lost money on that portfolio.

There is little doubt that interest rates will likely go up in 2014. If I am correct in my assessment of a higher GDP along with a reduction in bond purchasing by the Federal Reserve, then there is a high likelihood that the 10-year Treasury could go as high as 3.75% during 2014, which is higher than any currently held bonds. More likely the maximum will be 3.5%, but as is often the case when it comes to interest rates, they tend to overshoot rather than undershoot the fair rate. Unless interest rates jump to these high levels relatively quickly, you are almost assured to lose money in bonds again in 2014 since bond rates move inversely with interest rates. That is not to say that if you buy when interest rates are higher you cannot properly time the bond market. However, given the influence that the Federal Reserve can have on those rates on a daily basis, there have been many people who have lost a fortune trying to time interest rates, and I would not recommend it. Therefore, except for high-yield bonds, which also still carry a certain amount of risk, my projection for 2014 is that bonds will either be flat or lose money as they did in 2013.

As for my 2014 projection – rather than just picking a number out of thin air, I have spent countless hours taking so much into consideration and believe this year’s prediction to be much more accurate than 2013’s miss. The S&P group is forecasting that the earnings per share (EPS) for the 500 largest companies in the United States next year will be $118. There are numerous reasons why I think this number is too low. First, I do not think major corporations are going to increase employment during 2014, and a simple inflation increase of 1.5% of sales will fall directly to the bottom line. Additionally, there have been huge buybacks of corporate stock by large, cash-rich international companies. When you buy back your own stock in the open market, the earnings per share go up significantly since there are fewer shares outstanding. The most important reason I think this number is too low is that I am forecasting a higher GDP growth than most are. Most major financial houses are only forecasting GDP growth of 2.7% in 2014 while I still think it will be 3% or higher.

Therefore, I am increasing the S&P’s earning analysis of $118 by 5%, putting the EPS for 2014 at $124. To that, I would add a multiple of 17x. The long-term historic average of the S&P 500 has been a price/earnings of 18.7x over the last 25 years. Currently, the S&P is trading at about 15x the expected 2014 earnings. I think the main reason that I would like to use a higher multiple, but less than the historic multiple, is that there is really no alternative to stocks at the current time. If a client asks us to sell stocks, the first reaction would be “And then purchase what?” Given that cash is earning zero and my forecast for bonds is negative, stocks are really the only game in town. Once the general public realizes that the markets earned in excess of 30% in 2013, I believe there will be more and more cash being invested.

My calculation for the year-end 2014 S&P would be $124 a share times 17, yielding 2,108. Rounding down for estimates, I project the S&P to end the year 2014 at 2,100. The value of the S&P at the end of 2013 was 1,848.40 - therefore I am forecasting a total gain of the S&P in 2014 of 251.6 points, or 13.6%. Therefore my projection for 2014 is that the broad market will go up roughly 12-14%, which would be a spectacular year, given that the S&P was up 16% in 2012, 32% in 2013, and my projected 13% in 2014. This would be a spectacular run given the incredible negativity you see in the media these days.

One bit of advice that I would like to give to conservative investors who have fallen into the rut of only being invested in fixed rated instruments is that you really should consult with a professional. While there is certainly nothing wrong with bonds, you should not be invested solely in a sector with a high likelihood of losing money. Additionally, even those who expect to retire over the next 10 years tend to be too conservatively invested. As the 2013 year demonstrated, those who were nimble enough to get out of bonds and into stocks had a prosperous year. If you ignored the obvious signs as interest rates continued rising, your portfolio took a severe hit. While there may be a period in 2014 where bonds will become a good buy, there is no way to forecast that at the current time until interest rates start to rise.

Once again, we encourage you to speak with us if you have concerns about your portfolio. More importantly, we implore you - invest your excess cash immediately. As demonstrated in our prior posting, “Timing IRA Contributions”, the difference between investing at the beginning of the year versus the end of the year is dramatic, so invest now. If you have any questions regarding how to invest additional money or if you would like for us to propose an investment strategy that works for you, please feel free to contact us in order to discuss your future.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins

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