The final three months of 2013 saw further robust gains from developed-market stocks, but lackluster performance by bonds and many non-core asset categories trimmed balanced-portfolio returns.  Domestic large-company stocks posted three-month returns of around +10%.  Non-U.S. equity results were much more subdued, though still mostly in the black.  Real-estate- and commodity-related securities posted modest declines; gold fell -10%.  Despite higher benchmark yields (the 10-year U.S. Treasury note finished at 3.02%, compared to 2.61% at the end of September), many fixed-income (bond) investments managed to eke out slightly positive returns.

Within the U.S. market, the best three-month results came from companies in the Capital Goods, Financial Services and Technology sectors; underperforming groups included Communications Services, Energy and Utilities.  Small-company stocks trailed their large-cap counterparts by a small margin, while growth-oriented names edged out those in the value category.

Benchmark Performance – Equities

  Fourth Quarter 2013 Last Twelve Months
     S&P 500 Index +10.5% +32.4%
     Large-Cap. Core Mutual Fund Avg. (Morningstar) +9.7% +31.5%
     Small-Cap Stocks (Russell 2000) +8.7% +38.8%
     Non-U.S. Stocks (Developed – MSCI EAFE) +5.7% +22.8%


     Non-U.S. Stocks (Emerging – MSCI EM) +1.8%   -2.6%


Benchmark Performance – Fixed Income

  Fourth Quarter 2013 Last Twelve Months
    Barclays Intermediate Gov’t/Credit Index (taxable) +0.5% +1.5%
    Intermediate Municipal Mutual Fund Avg. (Lipper) +0.2% -2.3%



The remarkable performance turned in by U.S and many other major stock markets was surely the biggest story of 2013.  With a gain of +32%, the S&P 500 Index notched its best calendar-year performance since 1997; at +29%, the Dow Jones Industrial Average had its best year since 1995.  Small-company stocks were even bigger winners, with a benchmark rise of nearly 39%.  Even more unusual than the magnitude of the gains was the smoothness of the advance: for a second straight year, the S&P 500 never finished a trading day below the level at which it began the year.  Overseas, most developed-economy stock markets (e.g., those in Germany, France, the U.K., Japan) posted more moderate, but still double-digit, returns.  In stark contrast were results from the developing world: all four ‘BRIC’ markets posted losses for the year, with Brazil dropping more than -20% in U.S. dollar terms.

While stocks soared, economic performance continued to underwhelm: according to the International Monetary Fund, the global economy expanded by just under 3% (adjusted for inflation), marking the slowest growth since the recession year of 2009.  World growth was held back by a Euro zone struggling to emerge from recession and a Chinese economy embarking on a multi-year restructuring with the goal of more sustainable, but less robust growth.  Headline growth in the U.S. was only around 2%, but came despite substantial headwinds from tax increases and government spending cuts (‘sequestration’), as well as blows to consumer and business confidence due to ongoing dysfunction in Washington.  Hopeful progress came on multiple fronts: industrial production finally eclipsed its previous (2007) peak; a net total of 2.3 million jobs were created, allowing the unemployment rate to decline from 7.9% to 7.0%; and residential real estate continued to rebound, with many markets recording double-digit year-over-year price gains.  These improvements were sufficient to convince the Federal Reserve to begin the process of winding down its five-year program of extraordinary monetary stimulus.

The combination of gradually improving economic conditions and anticipation of a shift in Federal Reserve policy were enough to push U.S. bond yields sharply higher during the year, even though inflation – often a key determinant of interest rates – continued to decline.  The rise in market yields caused most categories of fixed-income investments to decline in price.  The twelve-month total returns on 10-year and 30-year U.S. Treasury securities were dismal: -8% and -15%, respectively, while Bill Gross’s flagship PIMCO Total Return fund logged a -1.9% return.

What’s Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1)         Dividend Income (for three months this is the annual yield divided by four)

2)         +/- Change in Earnings per Share* (average for S&P 500 companies)

3)         +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

            * based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to give us the +10.5% S&P 500 total return?

Fourth Quarter (October-December) 2013
Dividend Income +0.5% +10.5%
+ Change in Earnings +3.5%
+ Change in Valuation +6.5%
= Total Return +10.5%

Our read
:  Double-digit gains in stock prices combined with slow growth in profits are beginning to stretch valuations; a pick-up in economic activity should give earnings a helpful boost in 2014.

 Falling bond prices and flat-to-negative returns from many non-core investment categories (e.g., emerging-market stocks, commercial real estate, industrial/agricultural commodities, gold) made 2013 a year in which the simplest investment strategies provided the best results.  As one fund manager quoted in the Wall Street Journal pithily put it: ‘the more colorful your pie chart, the lower your return,’ as blue chip U.S. stocks handily outperformed nearly every other asset class, in some cases by as much as 40 to 50 percentage points.


After a disappointing 2013, global economic growth should pick up modestly this year.  In the U.S., consumer confidence and spending will be boosted by the past year’s real-estate and stock-market gains, ongoing improvement in the jobs market, and – with luck – a reduced incidence of headline-grabbing political dysfunction.  Meanwhile, incrementally better demand from both domestic and overseas customers, combined with increasing clarity regarding the tax and regulatory outlook, could spur business spending on equipment and software.  An important boost will come in the form of subsiding fiscal drag, as the anniversary of 2013’s tax increases and spending cuts will remove these from the equation; this shift will add at least a full percentage point to overall growth, pushing headline gains into the 3% range.

Among other developed-world economies, the Euro zone will be challenged by ongoing balance-sheet repair in the banking sector, as well as unwelcome strength in the common currency.  However, here too fiscal headwinds will abate as the bulk of austerity measures have been enacted.  Meanwhile, though it remains too early to proclaim the ultimate success of ‘Abenomics,’ the Japanese economy will continue to benefit from the program’s extraordinary monetary stimulus, and there are encouraging signs of budding corporate-sector optimism.

The prognosis for emerging-market economies remains something of a question mark.  In the short run, the Chinese economy seems to have levelled off following another mid-year ‘hard-landing’ scare; expansion in the 7% to 8% range seems likely in the year ahead.  Most observers were favorably impressed with the broad reform program that emerged from the Communist Party Central Committee ‘third plenum’ meeting in November.  Over the remainder of the decade, these reforms should increasingly channel resources away from overinvestment in heavy industry and infrastructure in favor of a more consumption-led growth model.  Elsewhere, Brazil seems headed for at least a mild recession, while political and structural obstacles cloud the near-term outlook for both Russia and India.  Second-tier Asian markets with strong manufacturing/ trade links to China (e.g., Taiwan, South Korea), and a reform-minded Mexico that stands to benefit from relative strength in the U.S. seem poised to outperform.

The anticipated uptick in global economic activity should provide support to corporate profits.  When fourth quarter results are tabulated in January/February, the aggregate 2013 figure for the companies that make up the S&P 500 Index looks set to rise by around 10% versus 2012.  Wall Street analysts are predicting a 13% earnings gain for 2014, which seems less implausibly optimistic than usual.

A final area sure to move financial markets this year is the evolution of Federal Reserve policy under the stewardship of its new Chairwoman, Janet Yellen.  It is important to emphasize that the recently announced ‘tapering’ of bond purchases (‘quantitative easing’ – or QE) does not signal an imminent end of stimulus; one strategist likened the change to ‘taking the Corvette from 160 m.p.h. to 140.’  As the Fed winds down QE, it will reemphasize short-term interest rates, and communication of its plans for manipulating those rates (‘forward guidance’), as its key policy tools.  And with unemployment still uncomfortably high and inflation dipping well below the preferred 2% level, rates will likely remain exceptionally low for another two to three years.  However, we have previously noted the complexity of unwinding unconventional stimulus; there are bound to be unforeseen consequences.  Moreover, financial markets are (sometimes notoriously) forward-looking; accordingly, we would not be surprised to see additional volatility – along the lines of May-June 2013, when ‘tapering’ was first mooted  – as the Fed feels its way forward.  But with benchmark yields already 125-150 basis points (1.25 to 1.50 percentage points) above their lows, we think a substantial adjustment is already reflected in the markets.

As we’ve noted in past quarter-end letters, the current stock-market rally is among the most mistrusted in memory.  Though many professional investors have become increasingly bullish in recent months, we have found that our clients’ concerns continue to skew heavily toward worrying that gains could be squandered rather than missing out on a rising market.  This skittishness seems due in part to fresh memories of the wrenching losses of 2008-‘09 (not to mention 2001-‘02).  The incongruity of soaring stock prices and a stubbornly sluggish economy likely adds to the sense of unease.  We think that lingering skepticism is a hopeful sign: bull markets usually end with a high degree of complacency leading to excessive risk-taking.

For our part, with the great benefit of hindsight, we view the astonishing market advance – +175% since early 2009, and +50% just since the start of 2012 – as quite rational: it reflects a powerful combination of gradually improving economic activity, leveraged into a much greater improvement in corporate performance, topped by a marked diminution in the perceived threat posed by ‘tail risks’ (e.g., financial-sector meltdowns, collapsing currency unions, a default on the U.S. debt, etc.).  Nor do we think the gains have necessarily left the market acutely vulnerable to an imminent downturn.  While valuation is increasing, it has not reached an alarming level: at around 17-times current-year (and 15-times year-ahead) earnings, the S&P 500 price/earnings ratio is only 10% or so above its long-term average.  History, moreover, provides little support for the notion that, following 2013’s 30%-gain, 2014 is liable to disappoint: 9 of 11 prior 25%+ calendar-year gains have been followed by further gains in the subsequent year.  All this said, we will be surprised if U.S. stocks rise as strongly, or as smoothly, as they did last year.  It’s been 30 months since the last 10%+ correction (in the summer of 2011, at the time of the debt-ceiling/credit-rating downgrade debacle), the kind of dip that usually occurs every 18 months or so.

We will also be surprised if portfolio balance (i.e., investment in complementary asset categories other than large-company U.S. stocks) continues to be as great a drag on performance.  With yields up considerably, and inflation set to remain low for some time, high-quality, intermediate-maturity (i.e., 5- to 10-year) bonds now offer considerably more reward than they did a year ago.  Likewise, the recent dramatic underperformance of emerging-market stocks and commodity-related investments makes them increasingly good long-term bets, although near-term uncertainties suggest a degree of caution is warranted.

We welcome your comments and questions regarding our management of your investments, and wish you a healthy and prosperous New Year.

Robert W. Phelps, CFA                                           Alan L. Purintun, CFA
Principal & Portfolio Manager                              Principal & Portfolio Manager


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