THE
stock market ended 2013 at record highs and with indicators of investor
optimism near best-ever levels. The enthusiasm is understandable after a
year that was the strongest for stocks in well over a decade — but
whether it is wise is another matter.
The
Standard & Poor’s 500-stock index rose 29.6 percent, to 1,848.36,
capped by an especially strong fourth-quarter gain of 9.9 percent. The
full-year increase was the biggest since 1997, and stock fund managers
made the most of the fertile environment, achieving their best results
since 1991.
The
average domestic equity fund in Morningstar’s database rose 8.3 percent
in the fourth quarter and 30.4 percent for all of 2013. The average
large-capitalization blend fund, the sort that would use the S.&P.
500 as a benchmark, was up 31.9 percent for the year. That beat the
price appreciation of the index but lagged the 33.2 percent total
return, which includes dividends, of the SPDR S.&P. 500, a large exchange-traded fund
that tracks it. Exchange-traded funds continued to grow in popularity,
to their largest year-end proportion ever. They accounted for 13.2
percent of fund assets as of November, according to Morningstar,
compared with 12.7 percent at the end of 2012.
It
was a difficult quarter for the bond market. A sharp rise in 10-year
Treasury yields last year, to 3.03 percent from 1.76 percent, sent
prices lower on longer-dated issues, although instruments of lower
quality and with shorter maturities fared better.
Treasury
issues were subdued for much of the year by the threat — and then the
fact — that the Federal Reserve would start to wind down quantitative easing, its purchases of Treasury bonds and mortgage
securities. The Fed announced in December that it intended to reduce
purchases by $10 billion a month from a starting rate of $85 billion if
suitable economic progress continued.
Quantitative
easing gave investors a reason to buy stocks all year, and the Fed’s
plan for a slow reduction of the program, with its promise to keep
interest rates low for a long time, gave them a reason to keep buying.
Although the impending announcement had been a source of dread, the
market had one of its best sessions all year when it occurred on Dec.
18, and the ebullient mood lingered until year-end.
As 2013 came to a close, the weekly Investors Intelligence survey
of investment newsletters recorded the most lopsided ratio of bulls to
bears — more than four to one — since 1987. Similarly, the weekly poll
of members of the National Association of Active Investment Managers, released on Jan. 2, showed one of the most bullish readings since the survey began in 2006.
But
while investors cheered, economists and corporate executives had less
to celebrate. Inflation-adjusted economic growth reported by the federal
Bureau of Economic Analysis reached an annual rate of 4.1 percent in the third quarter,
the most since 2011. Yet much of the strength resulted from inventory
buildup — things made but not sold — and from greater consumption by
necessity, not choice. Higher spending on health care and energy
accounted for most of an upward revision in third-quarter growth
reported in December.
An
increase in profits was tepid and similarly suspect. The research
service FactSet estimates that net earnings for S.&P. 500 companies
increased 6.3 percent last year, barely one-fifth of the index’s gain,
and much of the profit growth was attributable to the very low interest
expense engineered by the Fed.
THAT
so-so backdrop didn’t hinder the desire to own stocks. But with prices
seeming to outrun reality, some strategists and portfolio managers have
urged investors to rein in their enthusiasm. The new year may be far
less profitable than 2013, they warn, for three reasons:
the reduction
in Fed bond-buying makes higher interest rates more likely; earnings
growth is likely to remain sluggish; and the market’s spectacular run,
amid those smaller earnings gains, has left stocks expensive. Now that
the Fed has made its intentions clear, investors may focus more on
fundamentals, and they may not like what they see.
“I don’t deny that there have been a number of sentimental, emotional developments that have helped the stock market,” said Scott Clemons, chief investment strategist
at Brown Brothers Harriman Wealth Management. “The concern I have is
that the Fed has been a sideshow. The real show is what’s going on with
corporate earnings, margins and valuations. Earnings have been bouncing
along roughly in line with nominal G.D.P. growth.”
That
figure comprises real gross domestic product — what the Bureau of
Economic Analysis reports — and the inflation rate. Neither has been
expanding all that fast consistently, Mr. Clemons noted. Beyond the
economic backdrop, he says he believes that companies’ ability to
bolster profits without significantly increasing sales, through
cost-cutting and very low interest rates, has run its course.
That
inauspicious combination led him to forecast profit growth at a
mid-single-digit rate this year. He has continued to look for value, he
said, but with stocks starting 2014 trading at roughly 18 times
earnings, “it’s harder to find.”
Joseph R. Huber, manager of the Huber Capital Equity Income and Huber Capital Small Cap Value
funds, has been frustrated in his search, too. “It’s difficult to find
stocks in this market, even on a relative basis,” he said. He has looked
for value, and said it was especially hard to find among smaller
companies.
If
there are precious few cheap stocks in this market, how about in
others? Funds that specialize in foreign stocks gained 5 percent, on
average, in the fourth quarter and 15.9 percent for the full year —
strong by the standards of most years but barely half as great as
domestic funds’ performance. Europe was the best overseas region, with
portfolios there rising by an average of 28.9 percent in 2013; funds
invested in emerging markets were noticeably weak, up just 0.7 percent.
It
took Europe longer to start working its way out of the 2008-9 financial
crisis than the United States, so European companies and stocks are
widely seen as being in an earlier stage of recovery. Although raw
economic numbers look worse in Europe, the improvement from the depths
of the crisis is heartening investors.
“You have to be careful not to judge the recovery by U.S. standards,” advised Simon Webber, lead manager of the Schroder International Alpha fund.
Even
amid lackluster growth, corporate profits in Europe could improve
substantially, he predicted, because they are coming off a low base.
“European earnings are significantly below their peak” of the mid-2000s,
Mr. Webber said, “and the U.S. is back to its previous peak, so there’s
scope for significant recovery, which I expect to come through in the
next 12 months.”
He still counsels selectivity, with an emphasis on industries like banking, insurance
and staffing. As for countries, he prefers some with strong economies,
such as Germany, but also those that may be bouncing back. Spain, for
instance, “has made big gains in competitiveness and has the bones of an
export-led recovery,” he said.
Mr.
Webber also encourages careful choices in China. He suggests that
investors concentrate on segments of the economy that stand to benefit
from an emphasis on an improving quality of life, a mix that includes
retailers and businesses that help bring efficient and cleaner energy
use.
SELECTIVITY
by bond investors last year did little good, unless investors selected
high-yield or junk bonds. Those junk-bond funds, on average, rose 7.2
percent for the year, aided by a gain of 3.2 percent in the fourth
quarter.
The
average taxable bond fund returned 1 percent in the quarter and 0.9
percent for the year, dragged down by funds that focus on long-term
issues. They were hit especially hard by the climb in interest rates and
fell 6.1 percent for the year. An indication of poor 2013 performance
in long-term government bonds was the negative 14.4 percent total return
of iShares 20+ Year Treasury Bond, a frequently traded exchange-traded fund.
William H. Gross, manager of Pimco Total Return,
the largest bond fund with nearly $250 billion in assets, does not
expect the environment for bond investors to be any more benign in 2014
as the Fed’s assistance to them continues to wane.
“It
would be better for the bond market for the Fed to write a trillion
dollars’ worth of checks a year than not,” Mr. Gross said. With the
checks set to be smaller, “it’s just a question of where to seek
shelter.”
He
said he expected the Fed to keep its target for the federal funds rate,
at which banks make overnight loans to one another, at 0.25 percent for
at least two more years. That would lead him to stick to instruments
toward the shorter end of the yield curve, coming due in two to four
years.
Modest
economic growth “opens the door for credit, but not necessarily junk
bonds,” he added. That would encompass corporate issues of moderate to
high creditworthiness. He also recommends some foreign bonds,
particularly from Mexico, and closed-end municipal bond
funds trading at large discounts to their intrinsic asset values. Muni
mutual funds had a poor 2013, losing 3.4 percent, on average.
When
it comes to bonds, Mr. Clemons at Brown Brothers Harriman prefers even
shorter maturities than Mr. Gross, eight months or less.
As for stocks,
Mr. Clemons likes stable, financially strong sectors like consumer
staples as well as beaten-down niches like emerging markets. Such
exceptions aside, he and his colleagues have been selling into the
rally, and he advises extreme caution.
“I
don’t know if a bear market is on the way,” he said, “but I know that
the combination of low earnings growth, high margins, high valuations
and investor complacency gives you no margin for safety.”
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