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Frank looks ahead
at 2014...

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas."

—Paul Samuelson, economist, and Nobel Prize winner

We've just entered the New Year, making it the perfect time to take stock of 2013 and share some thoughts on how I plan to position your portfolio as we continue down the road called 2014.

There is no better place to start than to re-create the atmosphere that greeted investors at the conclusion of 2012. The country had just emerged from a bruising presidential election, and the fiscal cliff loomed large over the economy and the markets.

Without any action by Congress, steep tax increases were scheduled to take effect, threatening to tip the economy into a recession again. At the midnight hour, Congress managed to craft a narrow bill that raised taxes for the wealthiest Americans—about 1%—while enshrining the Bush-era tax cuts as law for the rest of the population.

It wasn't the so-called Grand Bargain that some had dared to hope for.

Nevertheless, the economy sidestepped the fiscal cliff, a stiff headwind for the market was removed, and stocks roared out of the gate in 2013, foreshadowing what would be the best year for the S&P 500 since 1997, according to data provided by the St. Louis Federal Reserve.

The three-legged stool Many are asking, "Why did we see the emergence of a ferocious bull market when the economy is still limping along?" It's a great question. The short answer: 2013 turned out to be the year that bad news was good news.

Let me explain. First, the economy has been limping along since it officially emerged from the Great Recession in late 2009.

With job growth in low gear and inflation even lower, the Federal Reserve embarked on a series of bond purchases, popularly called “quantitative easing,” or “QE” for short. Remember, by definition, rising bond prices equate to falling yields. The Fed's goal? Put downward pressure on yields in the hopes that consumers and businesses would borrow and spend, sparking job growth.

Reviews on the effectiveness of QE have been mixed, but one thing seems certain: The Fed's ultra-easy monetary policy has been a boon for the stock market.

Second, I wouldn't discount the impact from rising corporate profits. According to Thomson Reuters, earnings per share (EPS) for S&P 500 companies hit a record high in the first quarter of 2013, and subsequently broke the record in the second and third quarters, respectively.

Moreover, analysts are forecasting another high in the fourth quarter. True, economic growth has been substandard, but very modest revenue gains, coupled with a very keen eye on expenses, have been a tailwind for profits.

That leads us to the third leg of the stool: Many companies have more cash than they know what to do with, at least the major corporations. Given heightened levels of economic uncertainty and few opportunities to expand, companies are buying back stock (or borrowing at record low interest rates to finance purchases).

Yet it is not just the repurchases of shares that count, but whether companies are also selling new shares to the public. Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, summed it up well in December when he said, "We are starting to see excess buying, where the repurchases outnumber the issuance, and therefore, reduce the amount of shares in the marketplace. These lower share counts effectively shrink the supply of stocks and even if demand stays the same the prices will likely rise. Furthermore, fewer shares lead to higher “earnings per share” (EPS), and the market likes higher EPS."

While the repurchase of company stock has underpinned the market, dividends have also sweetened the pot. S&P Dow Jones Indices estimates that companies returned a record $310 billion last year in the form of dividends.

Finally, though I hesitate to call this a tailwind, Europe has quieted down. European banking woes haven't been put to rest, but the vicious headlines that swirled across the continent and created uncertainty in the U.S., especially in 2011, were mostly absent last year. Think of it like the fiscal cliff—for now, a hurdle removed.

Bond market: Dancing to a different tune
Early gains in Treasuries were replaced by jitters that QE was on the verge of being reduced by the Fed, and Treasuries responded accordingly. The 10-year Treasury yield, which began 2013 at 1.78%, ended at 3.04%. Note that rising yields did little to slow the equity juggernaut. This increase in interest rates didn’t put much more money into the pockets of bond investors, but it did equate to an increase in these rates of approximately 70%.

As you probably know, and as we have continuously repeated, a rising interest rate environment hurts bond investors (just as a falling rate environment helps them). As we’ve stated, rates rose sharply (comparatively) in 2013 and this caused a corresponding decline in the value of fixed income investments. Using the Barclays Capital Aggregate Bond Index to measure the performance of bonds, fixed income investors lost money for the first time since 1999 (that’s 14 years).

At the December meeting, the Fed finally announced it would reduce the $85 billion in monthly bond buys by a modest $10 billion, with promises of more cuts in 2014 if the economy cooperated.

My 2014 crystal ball
Baseball legend Casey Stengel once said, "Never make predictions, especially about the future." With that in mind, I'll cautiously peer into my crystal ball, however fuzzy it may be.

Everything that drove stocks to new highs in 2013 remains in place: super-low interest rates, expectations of further growth in corporate profits, and the belief that companies are likely to continue to return cash to shareholders. A continued acceleration in economic activity will likely lead to rising corporate profits which often leads to higher stock market valuations.

Some people have speculated that our recent record stock prices might be setting us up for a fall.

BCA Research, a highly respected independent research firm, concluded in December that U.S. equity prices are no longer cheap—no surprise on that front. But they were quick to point out that "various valuation indexes suggest the market is either fairly valued or borders on slight overvaluation."

BCA added that there is a clear link between price-to-earnings ratios (P/E ratios) and the yield curve, or the line that plots yields (in this case, for U.S. Treasuries) from the shortest maturities to those that go out 30 years.

A steeper yield curve is indicative of better growth potential and very easy monetary policy. As such, it often coexists with expanding P/E ratios. That's a plus for stocks.

Brian Westbury, my friend and chief economist at First Trust, is taking an even more sanguine view, as he incorporates today's low-rate environment into his models. Using a 10-year Treasury yield of as high as 4.5% (remember the year end rate was 3.04%), coupled with current profits, Westbury believes further gains may be in store this year.

Yet we're never really in the clear.

Questions being asked include:

What will the Fed do? Will the shallow recovery in Europe take root, or will banking woes resurface? Will China continue to grow, or is an economic hard landing inevitable? Will conflict in Washington rock the boat?

Could we see new problems surface in the Middle East? Historically, geopolitical headwinds have proved to be temporary, but that doesn't eliminate the possibility of heightened uncertainty over a short time period.

More favorably, will faster capital spending take hold, supporting the economy? And how will the energy boom continue to underpin growth?

What this means for your investments
No one, and I mean no one, can accurately predict the future. I know that seems obvious, but we've all seen those late-night commercials for tools that claim to effectively time the market.

Could we have a correction in stocks that pull the major averages down by 10%-15% or more? It's always possible. Corrections have a way of catching the consensus off guard, creating unwanted anxieties.

Yet most of the time, we need not be overly concerned. Besides, washing out excess optimism can set the stage for further potential gains.

  • I always stress that you must be comfortable with your portfolio.
  • There is always some uncertainty when investing. As we've talked about in our meetings, my goal is to help you mitigate that risk. But you must be comfortable with the level of risk you're taking as we set out to meet your objectives. If you are not, let's talk and recalibrate.
  • Stick to the plan. Markets rise and markets fall, but unless there have been changes in your circumstances or you've hit milestones in your life, such as retirement, stay with the plan. For example, it was tempting for many to cash out of stocks in early 2009. But hindsight has proved that a wholesale deviation would have been costly.
  • Rebalance. Last year's surge in equities may have knocked you out of alignment with your target stock and bond allocations. In December 2013 we began our year-end, tax related, rebalancing process for the express purpose of saving you money on your income taxes. In the year ahead, it’s likely we’ll take profits on some of the winners and selectively reallocate the proceeds into areas that we feel provide better “values.”
  • Choose high quality investments, diversify broadly, use low-cost investments whenever possible, and keep a wary eye on the impact of taxes on your investments. We focus the core of our low cost, highly diversified holdings. We will utilize tax free, municipal bonds when appropriate, harvest losses (for their inherent tax benefits), and correspondingly let our gains “run” so long as they do not make your portfolio too top-heavy in any one area.
  • Maintain our broad based asset allocation. Anxieties linger that we'll see further losses in bonds, and I agree, but that shouldn't be a reason to sell our bond/fixed income positions as some suggest. Fixed income investments are foundational pieces in our portfolios, and by diversifying across the many types of bonds: government, corporate and municipal, as well as across the spectrum of maturities, I believe we can manage losses while enjoying the volatility dampening characteristics of these types of investments.
  • Don't discount international. Emerging markets have been underperformers over the last couple of years, but the more developed economies in Europe have been stronger. The U.S. may or may not outperform the rest of the world in 2014, but over the longer term, I firmly believe that exposure to global markets is beneficial and helps to manage risk.

I realize complacency can sometimes set in following a euphoric rise, but we can guard against that with a portfolio crafted with your objectives and risk tolerance in mind.

I trust you've found the annual summary to be both educational and helpful. Should you have questions or comments or want to discuss any other matters, please feel free to reach out to me or anyone on my team.

As always, I truly value the trust you've placed in us, and I want to once again thank you for the opportunity to serve as your financial advisor.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Asset allocation does not ensure a profit or protect against a loss.

Stock investing involves risk including loss of principal.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.

Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply.

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