It Was A Very Good Year



As Frank Sinatra used to sing in one of my favorite songs, “It was a very good year.”  The Dow Jones Industrials were up 29.65%; the S&P 500 was up 32.39%; and the NASDAQ Composite was up 40.12%.  The Russell 2000 Growth Index of small growth stocks was up 43.3%.  The Health Care Index was up 41.46%; the Industrials were up 40.70%; and the Financials were up 35.63%.  The Alerian MLP (Master Limited Partnership) Index was up 27.58%.  The bond market did not do quite so well.  The Barclays U.S. Aggregate Bond Index was down 2.02%, and the Barclays 1-3 Year U.S. Government/Credit Bond Index was up just 0.64%.

It will be very difficult to repeat this stellar performance in 2014.  For one thing, the 10-year Treasury bond yield will more than likely stay fairly flat between 2.25% and 2.75% over the year.  Secondly, the stock market has risen so much since April 2009 that it will probably take a breather.  Our economy is going sideways to slightly up.  Middle income Americans are losing buying power because they are not getting wage increases.  The stock market has rallied for five years from a very low point, fueled by the Federal Reserve’s buying of government treasuries and mortgage-backed securities to keep interest rates low.  This cannot go on forever.  As we have said for several years, the stock market advance has been driven more by Price/Earnings Ratio multiple expansion than earnings growth.  This may be coming to an end.  After a great five years we now have more to worry about.  Bull markets do not last forever.  Generally they last about five years.

Federal Reserve

Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, Texas gave a speech to the prestigious Economic Club of New York in New York City on October 17, 2013.  His speech gives us reason to be concerned about the stock and bond markets.  His speech concerns the role of the Federal Reserve and its limitations and the role of Congress.  He says, “I came to speak to you this morning not of pleasant dreams but of the nightmare of fiscal indecision and political chicanery that emanates from Washington, the risk it poses to the reputation of our nation, and the limits it imposes on monetary policy.”

He quoted the iconic actor Errol Flynn who said that his legendary financial problems lay “in reconciling my gross habits with my net income.”  Fisher said, “This is the most concise description I can marshal to explain the problem plaguing our nation’s fiscal authorities.”

He said he has no doubt that we will go on indefinitely increasing the debt ceiling and that the full faith and credit of the United States government, in fact, will be at risk.  He says there is a tipping point but none of us know where that is.  I have included his entire speech for you to read.


Every year Barron’s magazine reports on what the Barron’s Roundtable of market experts think will happen in the current year.  I have included some of the commentary by some of the experts.  These include Bill Gross (Founder and CIO, PIMCO), Abby Joseph Cohen (Senior Investment Strategist, Goldman Sachs), Scott Black (Founder and President, Delphi Management), Felix Zulauf (President, Zulauf Asset Management), Fred Hickey (Editor, “The High-Tech Strategist”), Mark Faber (Editor and Publisher, "The Gloom, Boom and Doom Report") and Mario Gabelli (Chairman and CEO, GAMCO Investors).

Barron’s: After a stupendous year for U.S. stocks, 2014 is looking rather different.  Since the Federal Reserve and the bond market will be setting the tone, let’s start with our bond maven, Bill.  What will everyone be “Yellen” about this year?

Gross:  At Pimco, we don’t expect yields to keep rising, even in the face of Fed tapering [the Fed has started curbing its bond-buying].  When its asset purchases end, likely in late 2014, government bond yields will be dependent on the policy rate [the Fed’s target for the federal-funds rate, currently 0.25%]… Absent higher inflation and a policy-rate change, the U.S. bond market, and other bond markets, will be stable.

Is the market overly discounting a rise in the policy rate in 2015 or 2016?

Gross: Eurodollar futures indicate a policy rate of 3% to 4% in early 2018, but that is a long way off.  It’s another way of saying that the market sees a rate hike in early 2015.

Abby, what is your 2014 forecast for the economy?

Cohen:  The Goldman Sachs economics team is forecasting gross-domestic-product growth of 3.3%.  The sources of growth include less fiscal drag than last year, when the payroll tax was increased, and some improvement in domestic demand.  We are seeing improvement in the labor markets and household disposable income, and spending has increased.  This is evident in auto sales and housing.  Also, U.S. companies with strong balance sheets are likely to divert money from dividend increases and share repurchases to business fixed investment.

Black:  Unless we do something to improve fiscal policy, the economy will stagnate.  From 2000 through the end of 2013, real [inflation-adjusted] growth in GDP has been 1.8% a year.  It has been the slowest period since the end of World War II.  I don’t see how you get to 3.3% GDP growth.

Zulauf:  The stock market has been driven primarily by the Fed’s liquidity provision.  The world economy will disappoint.  The U.S. will perform best.  China is slowing dramatically, causing contraction in the emerging world.  Europe has seen an improvement in bond yields due to arbitrage opportunities, but has virtually no economic growth.  The U.S. could be the exception in seeing 2.5% or 3% growth, largely because consumer prices will remain depressed.  If I’m right, commodity prices will remain soft, and the U.S. dollar could be stronger.

Hickey:  U.S. household wealth grew by $30 trillion, to an estimated $80 trillion or more between 2009 and 2013.  What happens if some of that $30 trillion disappears as the stock market declines?

Faber: Who got the $30 trillion?  Not ordinary people.

Gabelli:  That’s not true.  Ordinary people have 401(k) retirement plans.  This idea of only the 1% having equity exposure needs to be fleshed out.

Faber:  The economic recovery is in its fifth year.  On March 6, the bull market in stocks will be five years old.  That’s long, by historical standards.  Sometime this year, the stock market could see a big tumble, as in 1987.  Then the long bond will rally and reward Bill Gross.

What will precipitate this crash?

Hickey:  When QE1 ended, the market fell by 13% in a matter of months, which caused the Fed to launch QE2.  When it ended, the market fell by 17.5%.  If Bill is right that the Fed will stop buying assets by year end, somewhere between now and then we are going to blow the stock market up.  Valuations are much higher today than when QE1 or QE2 ended.  The market is far less stable.

Gabelli:  The global capital markets had $85 trillion of debt at year end, and $62 trillion of equities.  Margin debt [borrowed money used to purchase securities] is at an all-time high.  Regulators ought to lift the margin requirement [the amount of collateral required in margin accounts] to let the air out of speculative bubbles without damaging the economy.

Are stocks overpriced now?

Black: Analysts’ consensus estimate for 2014 S&P 500 earnings is $121.48, up 13.3%, year over year.  That is ridiculous.  My estimate is $116.  At [its recent] close of 1842.37, the S&P was trading for 15.9 times expected earnings.  Based on history, it is about fairly valued.  The median in the postwar period is 16 times.  Small-cap stocks, as defined by the Russell 2000, are trading at 21.9 times this year’s expected earnings.  Mid-caps are trading at 21.1 times.  As Mario would say, you can always find cheaply priced stocks.  But large-caps are much less expensive today than small- and mid-caps.

         I expect interest rates to stay low as Yellen will be accommodative.  It isn’t impossible that the S&P 500 could deliver a total return of 10% to 15%, with dividends reinvested.  The market could be derailed if the Democrats and Republicans can’t agree to raise the debt ceiling, or Israel unilaterally attacks Iran, or the Fed abruptly abandons quantitative easing.  But, historically, stocks have done pretty well in years following an annual rally of 20% or more.

To what extent has the drop in commodity prices resulted in the waning popularity of commodities as an asset class?

Cohen:  Global enthusiasm in recent years led to demand for commodities by pension funds and active money managers.  Now there is an unwinding, with the slowdown in emerging markets.  We look at supply/demand balances.  On a 12-month basis, we’re not that enthusiastic about commodities as an asset class.

Felix, where do you see markets going this year, in the U.S. and the world?

Zalauf:  Interest rates have popped up in China, not because of central-bank tightening, but funding stresses.  There is a credit bubble.  If something goes wrong in China, it could set off a panic in other stock markets.  The Russian and Asian crises in the late 1990s touched off a 25% drop in the U.S. in a matter of weeks.  The market is building a top in the first quarter.  In the following months, there will be a window for such a panic.

          If we have a market panic and the S&P goes to 1600, the taper will be all over.  All the central banks will provide liquidity.  Some will buy stocks for the first time.  They are afraid of systemic risk.

As you can see the opinions of these experienced and very capable experts vary widely.  It will be a very interesting year.

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Jamison Monroe
Chairman & CEO