Year End 2013
When 2012 ended we marveled at the 16% increase for the S&P 500 in spite of an almost universal expectation of single digit returns. We were naturally hesitant when we theorized in the 3rd quarter of 2012 that equities would see double digit equity returns heading into 2013. We even had someone say that our expectations were “ludicrous and out of line with anyone else’s views.” What was the result? How about another stellar year, well in excess of 2012 as stocks rose by 32%? We said “wow” after 2012, so for 2013 we’ll say AMAZING!!!
Keep in mind that 2013 wasn’t without its pitfalls, gyrations, and angst. Does anyone remember the Fiscal Cliff? Cyprus? Japan? Syria? NSA Wiretapping? IRS activism? The Keystone Pipeline? Dodd-Frank? The bond market was one area that caused us indigestion, with the benchmark Barclay’s Aggregate declining for the first time since 1999 as the Fed discussed and then finally began tapering its unprecedented stimulus program. The government was another issue, with the federal government shutting down for a few weeks in a bit of DC theater reminiscent of King Lear-unnecessarily tortured. On October 1st the government, as expected, fumbled on the opening play of the Affordable Healthcare Act (aka Obamacare) and has continued to stumble ever since. It would appear that attempting to nationalize an industry that equates to 17% of GDP is more difficult than investing in an alternative energy car company.
The US economy gained some traction during 2013, but GDP growth was still far below average for this point in a recovery. Real GDP (gross domestic product less inflation) increased by 1.1% in Q1, 2.5% in Q2, 4.1% in Q3, and an estimated 2.6% in Q4. The third quarter was helped by an inventory build, while the fourth quarter may benefit from some catch up spending after the government shutdown in the third quarter. Overall GDP was helped by a reduction in net imports, specifically oil. As you can see from the next chart, US crude oil production has increased as a result of fracking, a technology that allows oil producers to extract more oil from existing wells.
Meanwhile, oil consumption in the US has been stable over the past twenty years as shown in the chart below. The increase in production and stabilization of demand has resulted in a measurable decline in net imports (the top line in the prior chart), which is additive to GDP.
There have been a number of other bright spots in the economy, some of which may be indicative of a sustainable rebound in 2014. Housing activity has been robust in spite of the jump in mortgage rates (see chart below). Industrial production (up 1.1% in Nov) has been improving. Auto sales have recovered to a run rate of just over 15 million units, well above the late 2009 trough of 9.4 million units. The unemployment rate has declined significantly to less than 7.0% from a peak of 10% in late 2009.
Our concerns for 2014 are wages, which remain stuck at 1988 levels and coincide with a high rate of underemployment; and low quality job creation. Additionally, the tax and regulatory structure is contributing to a record level of income inequality as the share of income to top earners is at all-time highs in the US. Finally, there is a detrimental impact of low rates: low investment and savings rates, which penalizes savers at the expense of borrowers. Low wages, rising taxes, and low savings rates keep discretionary spending at bay for the majority of Americans.
The US Government
The US government continues to amaze us with its ability to successively achieve higher and higher levels of dysfunction. Government spending, long on over-drive, continues to soar. The chart below shows the growth in federal spending since 1970 compared to the median household income. As you can see, federal spending has risen by 287% over that time period while median income has increased just 24%.
This massive increase has resulted in the federal government consuming an ever-increasing percentage of GDP, and this trend is expected to accelerate with the implementation of the Affordable Healthcare Act combined with the aging of the population. The next table shows that if no adjustments are made to the way entitlement payments are calculated, they will double as a percentage of GDP to 19% by 2050, a level that is in line with the long term share of GDP represented by tax receipts. In other words, entitlement spending will consume 100% of the country’s tax receipts, leaving defense and all other discretionary spending to be funded by debt.
The Federal Reserve has been busy these past five years, taking center stage in the battle to stave off a depression. While at the helm, Chairman Bernanke has been crafty in devising new strategies and mechanisms designed to fuel economic growth. While we don’t agree with all of his methods, we do applaud his efforts and creativity, especially given the impotent response from the federal government. We wish him well in his next role as he leaves the Fed.
New Fed Chairwoman Janet Yellen, and new Vice Chairman Stanley Fischer, will take over with a possibly greater task in front of them than that faced by Mr. Bernanke: how to unwind nearly $5 trillion (see table below) from the Fed’s balance sheet? As most investors know, there are two parts to investing: buying and selling. Mr. Bernanke proved adept at buying, but is leaving the selling to his successors. This selling, or unwind of the various quantitative easing programs, could easily be the most critical determinant of US economic success for the next 40 years. The risks are enormous, with significant ramifications on domestic and global GDP, rates, inflation, stock and bond markets, the stability of the dollar, and the ability of the US to fund the aforementioned deficits. One misstep could derail the fragile economic recovery and put the Fed in the position of reentering the markets for another round of quantitative easing.
In December the Fed began to cautiously unwind their most recent quantitative easing program by reducing their purchases of treasury and mortgage backed securities from $85 billion per month to $75 billion per month. After a fair amount of angst from the markets in the spring and early summer after a mere mention of this tapering, the market absorbed the actual news in December quite well. Once again the old adage “buy the rumor, sell the news” seemed to hold as the rumor had a much bigger impact than the news.
It seems the days of a quietly run independent Federal Reserve are over for the foreseeable future.
The US equity market was the star of 2013 amongst major markets, with the S&P 500 advancing an incredible 32% for the year. The market was driven by record monetary stimulus from the Fed, expanding price-earnings ratios (PE), low wage inflation, low interest rates, and an improving economy. As our good friends at Strategas Research stated, equities benefited from the TINA effect: There Is No Alternative. Bonds, inflation driven assets such as commodities, defensive assets such as gold, and interest rate sensitive assets such as real estate all had returns that paled in comparison to equities.
All sectors of the market increased, but the best performance came from the more cyclical sectors of the economy: consumer discretionary, industrials, and financials, as well as from health care, which each rose more than 33% during the year. The more defensive sectors, telecommunications and utilities, lagged during the year, advancing less than 10%. Investor appetite for growth was apparent.
Equity increases over the past few years have coincided quite readily with the timing of Fed action in the marketplace. The chart below shows that the dramatic rise in equities over the past 4 ½ years has been accompanied by record stimulus, and market declines have been associated with reductions in this stimulus. If this relationship were to hold, the obvious question for 2014 is what happens to equity markets as the Fed continues its tapering of bond buying?
In another sign that investors were willing to increase their risk appetite, 2013 was a strong year for IPOs. The number of IPOs in 2013 increased by 59% to 230, and the dollar volume of IPOs jumped by 31%. Companies continue to have huge cash hoards, but have been rewarded by the markets for both stock buybacks and dividends, typically funded by low cost debt and strong cash flow. Apple Computer (AAPL) alone announced a $60 billion stock buyback in 2014. The downside to this financial engineering is that companies are not investing in growth, either signaling they have few growth prospects or they still aren’t confident in the economic turnaround.
Fixed Income Markets
While many have been calling for an end to the 30-year bond bull market over the past five years, we held firm in our belief that yields would continue to decline. Last year we discussed our preparations for the end of the bull market in bonds that saw yields decline from the high teens to the extremely low single digits. While we are strong in our conviction that the Fed will continue to hold short term rates low, the rise in longer term rates that has coincided with an improving economy signals we could be at the beginning of a sustained period of rising rates. Tapering will certainly continue to impact the market in 2014, however, fundamentals should begin exerting their influence on rates. The yield curve has steepened, meaning longer rates have risen while shorter rates have remained anchored.
We mentioned in our 2012 end of the year missive that we were positioning our portfolios for an increase in rates, which came to fruition. Our strategy was to increase the amount of credit risk we were willing to take as the economy seemed to be getting traction, making credit more attractive. At the same time, we minimized interest-rate risk by shortening duration and generally avoiding Treasury securities. We also maintained positions in high yield bonds and developed market credit, both of which performed well. Our modest positions in emerging market debt did not perform as well due to concerns about rising rates and US dollar strength.
One reason we are concerned about bonds is their valuation. The following table, courtesy of our friends at Strategas, shows that bond valuations are the highest they have been in the past 50 years. While overvalued markets can certainly become more overvalued, we feel that we are at the inflection point in yields. The only caveat to our view is if the Federal Reserve or federal government were to make a significant misstep that pushes the economy back into a recession.
2014 will be a challenging year as the Fed begins reducing their bond buying, the negative impacts of Obamacare kick in, and equities look fairly valued while bonds may be overvalued. I wish you all a healthy, happy and prosperous New Year, and look forward to speaking with you soon.
“I firmly believe that any man’s finest hour-his greatest fulfillment to all he holds dear-is that moment when he has worked his heart out in a good cause and lies exhausted on the field of battle-Victorious.” Vince Lombardi
"Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." -Sir John Templeton