The fourth quarter of 2013 produced a total return of 10.5% for the S&P 500 Index (SPX), which exceeded the 9.6% average annual return for the index since 1928. It might be said that for stock investors, the four quarter was a good year.
For the year of 2013, the S&P 500 Index generated 32.4% of return, its third best year since 1960. The rally has been primarily attributed to improving economic conditions, but one has to be concerned that some investors are chasing performance – moving money from underperforming sectors to those that have recently performed the best.
In contrast to the performance of the S&P 500 Index, other market sectors, such as bonds, precious metals, and emerging market stocks generated losses in 2013. No doubt, many investors sold their positions in these sectors and used the proceeds to buy U.S. stocks.
Bonds produced losses for investors last year as interest rates continued to rise. The yield on the 10- year Treasury bond ended the year at 3.03%, up sharply from 1.76% at the beginning of the year. (That yield has since fallen back to 2.75% as of January 8.)
The Barclays Aggregate Bond Index, the broadest benchmark of the U.S. bond market, lost 0.1% in the fourth quarter and 2.0% for the entire year. Some long-term bonds lost more than 10% of their value in 2013.
The value of gold declined almost 30% in 2013. Some consider gold to be a hedge against inflation and general political and economic instability. Despite central banks’ stimulative monetary policies across the globe, inflation concerns seem to have lessened. The decline in gold prices appears to reflect a correction from speculative levels.
Emerging market stocks lost money in 2013 and have consistently underperformed U.S. stocks in recent years. While emerging market economies are expected to grow at roughly twice the rate of developed markets over the next five years, recent economic performance has been less than expected in major markets, such as China, India, and Brazil.
Although the investment industry continually warns investors that past performance cannot be considered a guarantee of future results, it seems that this caveat is typically ignored. When considering investments, whether it is stocks, bonds, real estate, or precious metals, it seems investors place more emphasis on past performance than value.
In my opinion, it appears that most investors are attracted to the investment that has recently gone up in price, rather than the investment that offers the best value.
For example, investors plowed money into U.S. stocks in 2013, despite less attractive valuations. Though I have no hard evidence to support this, my theory is when valuing stocks based on earnings (price/earnings ratio), equities are about 26% more expensive than last year.
Whether using future earnings, dividends, book value, or cash flow, the conclusion is the same, stocks are considerably more expensive than last year. In my opinion, stocks are probably not to point of being overvalued or speculative, but certainly, it is difficult to make the argument that U.S. stocks are cheap.
Does past performance for stocks tell us anything about future performance? Actually, it tells us that after a good year, it is best to be cautious (and after a bad year to be optimistic). This concept is known as “reversion to the mean.”
Using 86 years of historical data, when the previous year had above-average return, the following year trended 0.8% below average. In the 16 years following a 30%-plus year, the returns trended 2.3% below average. Does this mean stocks should be sold? Not at all, these returns are still better than the average for other asset classes, such as bonds or cash. However, it is good to temper expectations following a strong year such as 2013.
While recent economic strength (higher GDP and lower unemployment) is positive for stocks, less monetary stimulation from the Federal Reserve will likely have a negative effect. The Fed announced it will begin this month to taper its bond buying program, which is likely to result in an increase in interest rates. Higher interest rates are generally negative for stocks, since they increase borrowing costs for both corporations and consumers, which has a detrimental impact on consumption and earnings.
Last year marked the fifth consecutive year of positive returns for stocks, a period which followed one of the worst bear markets on record. Investor psychology moves along a wide spectrum ranging from fear to greed.
In my opinion, the investor money flowing into Twitter (TWTR), Tesla (TSLA), and Bitcoin may be a sign of speculative excess in the market.
I concluded last quarter’s letter with the same cautious tone that I have now. What followed was one of the best quarters on record, which demonstrates why I do not believe it is possible to time the stock market. While 2013 was great, keep in mind that the S&P 500 has suffered losses in 29% of the last 86 years.
Corrections and bear markets are inevitable, but also unpredictable. So when the stock market looks a little frothy, it is best to stay focused on owning good quality investments with reasonable valuations and maintaining adequate diversification.
DISCLAIMER: The investments discussed are held in client accounts as of December 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Investors cannot invest directly in an index. Indexes have no fees. Past performance is no guarantee of future results.
