Stocks Look Good in 2014, but Stay Vigilant

The backdrop indicates the equity market appears to have a low probability of a large drop, but that doesn’t mean positive returns are guaranteed or that investors can be apathetic.

Domestic stocks ripped in 2013 and ended the year strong.  That’s great, but where do we go from here?  I am firm believer that investors should focus on risk, not return.  So let’s quickly analyze three risks to the domestic stock market:

• Fed tightening and rising interest rates can have negative ramifications on the equity market:
• If quantitative easing ends the reduction of “money” in the system will be small.
• The Fed will keep short-term rates very low for some time, perhaps until 2016, as labor markets and inflation remain weak.
• When longer-term interest rates rise from low levels it has been positive for stocks.

• During a recession earnings and valuations fall leading to lower stock prices:
• Currently though, the recession risk appears to be low.  While we look at a variety of economic indicators, let’s focus on the yield curve as history indicates that the last five recessions were preceded by an inverted yield curve (long-term rates > short term rates):

• Valuations are too high especially given the record profit margins:
• We view intermediate-term valuations as high (Shiller PE, Market Cap to GDP, Q Ratio); however, none of these say anything about the near-term.
• Shorter-term metrics indicate we are slightly above average, but nothing alarming.
• We concede profit margins are high, but outside of rising interest rates we struggle to find a catalyst to change that.  
• Further, history suggests that valuations can expand even if earnings fall unless they are at bubble levels (they are not) or a recession is on the way (see #2).

Succinctly put, when looking at the market in 2014 a low recession risk + an accommodative Fed + non-bubble valuation levels = a market that doesn’t appear to have a high probability of a large drop.

Having said that, there are still a few reasons for concern: 

1. The higher level of intermediate-term valuations indicate lower real returns over the next 10 or so years
2. The above premise is wrong, in particular the impact of the Fed and interest rates
3. Something unforeseen

As a result, moving forward it’s important to stay up the quality chain, allocate to absolute return-ish strategies, look outside our own market (international equities appear to have more attractive valuations) and pair back exposure when the market has historically been more susceptible for a large loss.  

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

Despite Falling Prices, Fixed Income Still Has a Place

Investors need to balance the expected fall of bond prices (portfolio ladder, tactical managers) with the benefits (equity hedge, price stability) that fixed income brings.

The 10-Year hit 3% at the end of 2013 while the Aggregate Bond ETF fell just under 2%:

Not to beat the thesis to death (see the bold paragraph here), but moving forward rates are expected to rise.  If we assume this to be the base case and bond prices fall, a logical question is why hold bonds at all? 

To answer that, let’s first examine the roll of a fixed income portfolio: 

• Despite being correlated over longer time periods, bonds can provide stability in the event equities fall.  From August 2007 to March 2009, using monthly closes, US stocks had an annualized return of -30% while US bonds had an annualized return of 6%.  Diversification away from equities with bonds minimized portfolio volatility.
• Utilizing the same data going back to 1970, we see the max drawdown on US stocks was 51% while for bonds in was 13%.  Thus, historical returns indicate the largest amount of risk in a portfolio is from stocks.
• See the above, that even with a 70% plus climb on the 10 year interest rate, AGG was only down 2%.  For returns of other Fixed Income ETFs, see here.
• A caveat to the previous bullet is making sure the portfolio’s duration risk (the sensitivity to interest rate changes, the higher the duration the greater susceptibility to rising interest rates) is managed.  If we look at TLT (iShares 20+ Year Treasury Bond) the duration is over 16 years and the ETF was down roughly 17% in 2013.  

To summarize, a fixed income portfolio with managed duration risk can provide a hedge against a falling equity market and is not at a high risk for large principal loss.  Still, we are left balancing the prospect of rising interest rates with the diversification benefits that fixed income bring:

• Laddering individual bonds or ETFs with a set maturity assures that an investor face value of the bond back (assuming no default) and can lessen the sensitivity to interest rate changes as bonds that come due will be re-invested at higher rates.
• Utilizing tactical managers who can enhance returns even if interest rates are rising.
• Find attractive relatively attractive yields in fixed income (e.g. municipal bonds).

While these ideas attempt to weigh rising rates with diversification, ultimately there is no free lunch – any move to hedge against rising rates probably reduces one’s ability hedge against a falling equity market.  It’s imperative each investor recognizes this and then decides on his or her own course of action.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

2013 and Beyond – The Bad, and The Ugly

Negative ETF Ranking - 2013
9	-1.37% - shares International Treasury Bond ETF (IGOV)
10	-1.83% - iShares S&P GSCI Commodity-Indexed Trust (GSG)
11	-1.98% - iShares Core Total Aggregate U.S. Bond ETF (AGG)
12	-2.00% - iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)
13	-3.44% - iShares National AMT-Free Muni Bond ETF (MUB)
14	-3.64% - iShares MSCI Emerging Markets ETF (EEM)
15	-6.09% - iShares 7-10 Year Treasury Bond ETF (IEF)
16	-6.73% - iShares Emerging Markets Local Currency Bond ETF (LEMB)
17	-28.33% - SPDR Gold Shares Trust (GLD)

Shockingly, not every asset class went up last year.  I say shocking because usually when stocks are hot nobody really cares what anything else is doing.

Last post I covered the ETFs that finished in the black last year and what we should expect moving forward.  This time I will cover the ETFs that finished in the red in 2013 (with the help of this file).  Again, when looking forward I am using this thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk.  Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat.  On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap.  The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

I will again mention the caveat that what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned and when things change portfolio and thesis adjustments will be made accordingly…

And now, the ETFs that had negative returns in 2013…

• IGOV – 2013:  International treasuries almost finished positive, but alas they finished with every other fixed income asset class.  They did finish the second half of the year very strong with the help of a weaker dollar.  Moving Forward:  While the US is pulling in the reins on QE – pushing our yields higher and bond prices lower – other countries are expected to remain easy or possibly become more accommodative (see Japan’s “success” with their own QE).  This would push their yields lower (or stable) and prices higher, but also cause their currencies to fall and thus washing out any positive.  Thus, an investment that is USD hedged could provide some boost.
• GSG – 2013:  The commodity chart looked a lot like USO last year, but worse as it includes agriculture and precious metals.  Commodities look to be in a range, and while that’s subjective the alternating black (Q1, Q3) then red quarters (Q2, Q4) would appear to validate that.    Moving Forward:  see USO (note: energy and industrial metals make up the bulk of index).
• AGG – 2013:   The pulse of the US bond market had its first negative calendar year return since inception and didn’t break its intermediate-term trend for the last eight months of the year.  Interestingly though it only had one negative quarter (Q2).  Moving Forward:  Assuming interest rates to continue to rise in 2014 it should yield another negative year for bonds.  While it appears interest rates may have hit a secular bottom in 2012, it’s important to remember that bonds hedge against a decline in risky assets (note: this has held as of late with equity markets off their highs and AGG moving up) and that they present much less risk (unless they are high yield or high duration) in terms of large capital loss.  Finding a balance between rising rates and the portfolio hedging benefits fixed income brings should be the goal.
• LQD – 2013:  See AGG, though the Investment Grade Corporate Bond LQD did break its intermediate-term downtrend at the end of the year.  Moving Forward:  See AGG.  There doesn’t appear to be much room for investment grade spreads to compress any further, so outside a 2008 credit event I would think they will have a high correlation with Treasuries.
• MUB – 2013:  Munis were hit harder than their taxable counter parts in 2013 with Detroit’s bankruptcy taking center stage.  While they did recover in the later part of the year, MUB like AGG finished the year below its intermediate-term trend for the last eight months.  Moving Forward:  Quick math, 3% yield on MUB equates to a tax effective yield at the 40% bracket of 5.00%.  AGG has a yield of 2.32%.  So if you are in a higher tax bracket, pick out some attractive munis, ladder them by maturity, hold to maturity, and you get a decent yield with not much interest risk. Note: as interest rates rise prices do fall, so prepare to watch your values drop, but if you hold to maturity you get the face value back.
• EEM – 2013: While EEM finished with two positive quarters and the last three months above the intermediate-term trend (barely), it still couldn’t overcome a poor start to the year as money moved out of Emerging Markets when our interest rates moved up.  EEM is also over 60% below its 2008 peak.  Moving Forward:  Even more so than developed markets, emerging markets appear to have an attractive relative valuation to our market.  Much of this is likely due to some longer-term demographic and geo-political issues and is especially true of the ones that got beat up last year (Russia, China).  Further, a sharp rise in US interest rates could continue the capital flow out of emerging markets.  Thus, while there are opportunities for upside until the trend reverses it’s hard to have much conviction.
• IEF – 2013: See AGG.  Moving Forward:  See AGG, though I think it makes sense to take a more tactical (over and under weighting when the market dictates) approach to the 7 – 10 year Treasury space.
• LEMB – 2013:  See EEM; rising domestics rates equates to capital moving from emerging markets local currency bonds back into US markets.  Moving Forward:  See EEM and IGOV.  While rising domestic rates would continue to be negative for emerging market bonds, a USD hedged exposure could be a nice boost.
• GLD – 2013: The gold chart for the year went pretty much straight down.  You can take your pick why: higher interest rates, decrease in systemic risk probability, lower inflation.  But at the end of the day you see three out four negative quarters, the whole year below the intermediate term trend, and down nearly 30%.  Moving Forward:  All three items I listed for gold’s 2013 decline are still in place.  Maybe one of those reverses and this turns into a great contrarian trade, but until the trend changes it’s difficult to allocate dollars to gold.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

2013 and Beyond – The Good

2013 is a wrap!  What a year it was if you invested solely in US stocks.  Just a guess, but I would wager some investors probably will think now is a good time to get undiversified.  That could work in 2014, maybe even longer, but ultimately other asset classes will begin to outperform and a diversified portfolio will provide good relative returns with lower volatility. 

But that discussion is for another day.  Below are some observations on ETFs (listed at the top) we look at that yielded positive returns last year.  I used this file to help make those observations.  For each ETF, I summarized 2013, and then outlined what should happen moving forward, based on the following thesis:

Growth should accelerate and, despite the “taper”, given the benign inflation outlook the Fed should stay accommodative, which would provide a good tailwind to stocks along with a reduction in systemic risk.  Still relative valuations in the US, particularly small caps, are now higher and at or slightly above their near-term average and the prospect of rising interest rates could pose a threat.  On a relative value basis, international markets look attractive where developed market growth should also pick up and while emerging markets face secular headwinds they do appear cheap.  The aforementioned backdrop should cause long quality US interest rates to rise and strengthen the dollar; however, other countries could embark on programs to bring long rates down.

Will all that happen?  Probably not, but these are my conclusions based on the current environment.  Of course as the markets and facts change so will the above thesis; in other words, as I have pointed out before, nothing is static.

Making predictions is a futile business, so what I attempt to do is make assumptions (i.e. NOT a price target) based on a more global thesis like the aforementioned, with the caveat that when things change portfolio and thesis adjustments will be made accordingly… 

• IWM – 2013:  US Small Cap stocks were best in show and never came close to breaking their intermediate-term uptrend (roughly 10% above the 10-month moving average).  Small Caps leading Large Caps is a good sign to market observers, though they also lagged a bit (still up over 8%) in Q4 and is something to keep an eye on.  Moving Forward:  This equity market segment seems relatively pricey to others and above average.  While the environment is conducive toward continued appreciation, I prefer higher quality companies with strong balance sheets that tend to land in the large cap space (SPY) in case some of those conditions reverse or something unforeseen happens.  Still, the trend in US stocks (this includes SPY) is overwhelmingly positive and as a result our risk metrics have not been triggered, in fact IWM and SPY are far from them.  So until the environment changes or the risk metrics tell us otherwise it’s difficult to go against the market.
• IVW – 2013:  Growth had little difference from the Value stocks ETF, thus if you were invested in stocks it really didn’t matter much.  Moving Forward:  see SPY/IWM.
• SPY – 2013:  The S&P 500 ETF that everyone looks at really ripped and was up over 30% on a total return basis.   Q4 was also the strongest quarter of the year and the index hit its high in the last week of the year.  Like IWM, SPY never came close to breaking its intermediate-term uptrend.   Moving Forward:  See IWM, though valuations are more reasonable than small caps and probably at their average.  I will again note, I prefer the quality companies moving forward that capture part of the up move, but also avoid some of the down move in the event the market reverses course.  Lastly, a major fundamental equity concern is what happens as interest rates rise; however, in this environment rising interest rates have historically been a benefit to stocks.
• IVE – 2013:  see IVW.  Moving Forward:  see SPY/IWM.
• EFA – 2013:  Investing in developed international market stocks netted 20%+ though still had a decent lag relative to domestic stocks.  The ETF is also still below its 2007 peak, but it’s close to making a new high on a total return basis.  Moving Forward:  Looking at prior returns and research, these markets tend to be a better relative value than our own stock market.  What this doesn’t mean is that outperformance will happen overnight.  Further, the trend is NOT your friend.   What it does mean is that there are some opportunities here, especially as growth in those economies picks up. 
• USO – 2013:  This is the first significant relative underperformance as the oil ETF’s return was a tad under 6%.  Moving Forward:  Typically cyclical commodities tend to rally more late equity cycle (see big Oil rise in 2007 and 2008 before it cratered), so assuming the equity market rally still has legs, I would expect the lag to continue.  Further, many investment based countries (e.g. China) are trying to shift to a more balanced economy.
• HYG – 2013:  Only bond asset class up for the year, which isn’t surprising given high yield is more correlated with equities and has minimal duration risk.  Moving Forward:  Environment should still be supportive.  However, while spreads (the difference between Treasuries and a similar high yield bond) have been narrower before, I do wonder how much juice is left in the squeeze?  Just be careful as high yield bonds won’t provide a hedge if riskier assets stumble.
• IYR – 2013:  Logic would dictate real estate would perform better given a big bullish economic story last year was the increase in home prices, but IYR barely finished the year in the black.  The chart looks eerily similar to the Treasury ETF, so there appears to be a correlation with interest rates.  Plus REITs outperformed stocks every calendar year since 2009 except last year, so maybe much of those gains were priced in.  Moving Forward:  The correlation between real estate and stocks broke down for much of 2013, but did move together prior to that.  Still, steadily rising interest rates with minimal inflation should result in lackluster performance and a loose correlation with bonds. 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.