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Investment Commentary

Fourth Quarter 2013 Investment Commentary

For the year 2013, the Vanguard 500 Index fund was up 32%--the best performance since 1997. There was substantial divergence among sectors and industries. For example small cap growth earned 43% while utilities gained 8% as investors worried about how rising rates would affect interest-rate sensitive securities. International stocks of developed economies gained 21.8% as represented by the Vanguard FTSE Developed Markets ETF. There was significant divergence among developed international stock markets also. For example, the Nikkei 225 index finished 2013 up by 57% while the FTSE 100 index was up 14%.

But, the results for asset classes other than U.S. and other developed market stocks were not so favorable.. The Vanguard Total Bond Market Index lost 2.3%, the first calendar-year loss for bonds in 14 years. Muni bond prices dropped, with at least part of the loss due to financial challenges in a number of municipalities, especially Detroit and Puerto Rico. And don’t forget about the local challenges with our own Jefferson County. U.S. Gov. Treasury Inflation-Protected Securities lost 6.7%. The Citigroup World Govt. Bond Index lost 4.0%. The JPMorgan GBI-EM Global Diversified Index (emerging-markets stocks) lost 9.0%. The DJ-UBSCI (commodity futures) lost 9.5%. Perhaps as a result of low inflation, gold prices were down 28% in 2013 (the biggest loss in 30 years) and the Market Vectors Gold Miners ETF (representing gold mining stocks) lost almost 55% of its value. Silver was down 36%. The Vanguard REIT index (representing real estate) earned a bit over 2% for the year.

Most agree that QE and ZIRP (monetary policy) were the major source of support for rising global stock markets in 2013. When Dr. Bernanke made mention of the possibility of tapering the Fed’s monthly bond buying in May of last year, the stock and bond markets had a “taper tantrum” and dropped significantly. The Fed subsequently backed down on the possibility of tapering. But last month when Chairman Bernanke announced the first actual reduction in the Fed’s monthly bond buying, the stock market yawned, and continued to rise.

The Global Economy

The global economy improved in certain areas during the year. On a year-over-year basis, the U.S. economy grew at a real (inflation-adjusted) rate of around 2% in 2013, through the third quarter. Europe finally emerged from recession, and the United Kingdom and Japan also generated modest growth. Emerging-markets’ growth was disappointing in 2013, but they may benefit from improved export demand in developed markets in 2014. The leading indicators index, produced by the Organization for Economic Cooperation and Development, recently rose above 100 and is increasing. This is an indicator that economic expansion is underway. The indicators are designed to provide early signals of turning points between expansion and contraction of economic activity, and are based on a wide variety of data collected by the OECD from its 33 developed country members plus a few emerging countries.

The J.P. Morgan Global Manufacturing Purchasing Managers’ Index hit its highest level since February 2011. This indicates an accelerating economic expansion. The PMIs are based on monthly surveys that provide advance indication of what is happening in the economy by tracking changes in production, new orders, inventories, employment, and prices. Developed country central banks are likely to remain highly accommodative for the next year or two by holding short-term interest rates at extremely low levels and, in some cases, also providing additional liquidity via quantitative easing through bond purchases.

The U.S. Economy

Even though it’s still below average, especially for a recovery period, the U.S. Economy is slowly improving. Here are some indicators:

  • The housing market continues to improve. For example the S&P/Case-Shiller Home Price Index was up 11% from a year earlier. CoreLogic reports the percentage of homeowners who owe more than their homes are worth fell to 13% (as of the third quarter) compared to 22% a year ago. 
  • The rise in U.S. stock market valuations and the rise in home values improved the “wealth effect”.
  • The labor market continues to gradually improve. (But much of the decline in the unemployment rate has been driven by a drop in the labor participation rate to 30-year lows and a large portion of new jobs are low-paying jobs.)
  • Debt reduction continued.  
  • Inflation is low
  • The U.S. federal budget deficit came down a lot over the past year

As a group, economic improvements support an increase in consumer spending, or at least a decline in further consumer belt-tightening. Economically this spending is a good thing. Call me old fashioned…I’m concerned about increased spending. Even after a rebound from the 2% bottom, the U.S. household saving rate is still relatively low at bit over 4%, despite a shift from the worst to the best demographics (baby boomers) for saving. My personal observation is that, in general, people are not saving enough to support their standard of living. And, in my observation, materialism is pushing up most peoples’ standard of living.    

Inflation or Deflation?

Inflation in the United States (and globally, with a few exceptions) is low and is being held back by subpar growth and significant slack (excess capacity) in the economy. While some commentators talk about the inflationary risks from overly accommodative Fed policy, other commentators talk about the risk of continued disinflation (a falling inflation rate). In 2013, the price index for personal consumption expenditures (PCE)—the Fed’s favorite measure of inflation—fell further below the Fed’s target of 2%. As of the end of November, the core PCE index (which excludes food and energy prices) stood at 1.1%, its lowest level since early 2011. The headline PCE inflation rate (which includes food and energy prices) was just 0.9%. On the other hand, if the economy gains some momentum and unemployment comes down further we will likely see increased wage pressures, which would put some upward pressure on inflation. (Rising wages would also pressure corporate profit margins, which remain near historical highs. This would have negative implications for earnings growth and stock market performance.)

Some experts point out that there are many ongoing deflationary forces in the world. It seems logical that aggressive monetary and fiscal stimulus have probably prevented or delayed deflation. The government fears deflation because it reduces the revenues they can spend as corporate and personal incomes fall and taxpayers fall into lower brackets. Deflation would cause Social Security and other benefits to be reduced whereas inflation would cause them to be increased.

Most of the media are obviously government supporters for one side or the other. But I read, listen and try to learn. It appears that the government and most of the media are in favor of inflation. For example, I read the Wall Street Journal which is apparently in favor of inflation and warning about the possibility of deflation. For example, a recent WSJ article indicated, “Anxieties are rising in the euro zone that deflation—the phenomenon of persistent falling prices across the economy that blighted the lives of millions in the 1930s—may be starting to take root as it did in Japan in the mid-1990s”. Last week we replaced all our computers. I was not “blighted” by the fact that our computers are more powerful and yet cost less than they did five years ago. Maybe it is highly indebted governments that need inflation…not consumers.

As you can see, I am not willing to offer a guess as to whether inflation or deflation will win out but this is very important. One reason is because it significantly affects the outlook for bonds. Over the past several years, our clients’ bond allocations have ranged from 15% to as much as 80% of our various account allocations, based on each client’s risk tolerance. Bond valuations increase in deflation and decrease in inflation. Gold, as well as other commodity prices are also affected. So it is my duty and responsibility to our clients, to carefully consider the potential outcome of these conflicting forces every day.  

Investing in 2013

Year 2013 was an unusual year. The best strategy (with perfect hindsight) was to buy a major U.S. stock index at the beginning of the year and spend the rest of the year fishing. (Unfortunately, I didn’t do much fishing last year.) Among major stock markets, only the Japanese Nikkei 225 index outperformed the S&P 500. The “sophisticated” investment strategies lagged the indexes, including the very high-fee “hedge funds”.

Diversification is a proven investment strategy that works over time. It is a strategy that I have always used for my clients to decrease risk without a proportionate decrease in potential return. Using diversification was detrimental in 2013 but I have no plans to abandon the strategy now. (“Divide your portion to seven, or even eight, for you do not know what misfortune may occur on the earth.” Ecclesiastes 11:2)

The “word on the street” is “don’t fight the Fed,” but embrace it and prosper from the bounty (or something like that). But I continued to use long-term, proven, fundamental investment management and financial planning principles. Volatility was relatively low in the overall U.S. stock market in 2013, with only five selloffs of 2% or more in the S&P 500. The worst was in May when the Fed brought up the possibility of reducing its $85 billion per month in bond purchases. Investors (including me) thought the Fed would do that and increase interest rates as well.

I was unwilling to sell safer investments and jump recklessly into the best performing U.S. stock sectors and sub-sectors last year. I purchased some special niches (most of which performed very well) but for the most part I emphasized large-cap, high quality stocks with healthy balance sheets, and “wide moats” (sustainable competitive advantages). I also emphasized defensive sectors such as reliable dividend payers, healthcare companies, consumer staples, and foods (and I still do). All year I thought the outlook for U.S. stocks was uncertain because it was being driven by the Fed’s monetary policy, unsustainable profit margins and P/E expansion, not by fundamental growth in corporate revenues and pricing power (still do). In case you have forgotten, P/E expansion just means that people are willing to pay more per dollar of earnings. Statistics indicate that 67% of last year’s increase in U.S. stock prices can be attributed to a higher P/E; only 33% can be attributed to earnings growth. And a meaningful part of earnings growth resulted from companies buying back their own stock. Companies took advantage of very low interest rates to fund share buy-backs, thereby reducing the number of shares outstanding. This, of course, resulted in higher earnings per share for each remaining share outstanding.

Investing in 2014

I have significant concerns about investing in 2014. According to Robert Shiller’s Cyclically-Adjusted Stock P/E Ratio, the P/E on the S&P 500 is 34% above its long run average. This indicates that stocks are significantly over valued. It doesn’t appear that the economy and profit growth will be strong enough this year to offset the negative effects of tapering. Therefore, my investment theme is to continue to emphasize risk management.

As a part of my risk management process, I plan to continue to emphasize high quality stocks. High quality stocks have under-performed low quality stocks recently. Perhaps this reflects the “dull” nature of their businesses or maybe it reflects expectations that newcomers will overtake quality companies’ competitive edge. Or maybe because of greed and people playing follow the follower and pushing up the prices of low-quality, high-flying stocks. In my opinion, the current valuation discount of high quality stocks to low quality stocks results in quality now being priced to do relatively well, with a relatively low risk level. There are various definitions of quality but their characteristics include a history of stable earnings and dividend growth, high returns on equity, high profit margins and low debt levels. Finding high quality stocks is so easy even I can do it by using top notch resources such as the Standard & Poor’s Quality Rankings, which have been compiled since 1956 and rank common stocks based on the long-term growth and stability of a company’s earnings and dividends.

I think there is a reasonable possibility that we will see another significant rise in the stock market over the short term due to a rush of individual investors who have not yet jumped in. Major tops are often reached when everyone who can be sucked in has been sucked in. Traditional savers apparently continue to be discouraged with the very low interest rates that they are receiving. Please don’t fall for any of the many new sales gimmicks that are being conjured up and promoted right now by financial firms. They are designed to take advantage of a bad situation for vulnerable people. (Someone called me yesterday to explain his firm’s new “inflation rotation” strategy.) One area in particular is razzle-dazzle variable annuities, especially “indexed” annuities.   

But as I have indicated previously, I think it is obvious that there is a disconnect between fundamental reality and current stock valuations. And I am a firm believer in reversion to the mean. I think a shock in the investment climate could occur due to a number of possible catalysts. Shocks could result from: Obamacare, nukes in Iran, a breakup of the euro, a default on payment on some county’s government bonds, peak oil, the Arab Spring, a “hard landing” in China, etc.  


While there have been fundamental improvements in the global environment over the past year, many big-picture risks remain. I am not confident in predicting that any of these risks will actually play out, but I think many of them have a reasonable likelihood of happening (and many of these risks are interrelated, meaning if one happens others are more likely to occur as well). If so, the consequences for financial markets and asset prices would likely be severe. Although there don’t appear to be any near-term catalysts, I believe it remains prudent to manage my clients’ portfolios with these risks—and their potentially significant market impacts—firmly in mind. This is particularly so, given the assessment that current valuations for U.S. stocks (in aggregate) are not sufficiently pricing in the potential impact on the market if these risks actually do play out.

On the other hand, we live in the greatest country in the world. We have much to be thankful for. I am thankful for every client and I am thankful for the opportunity to serve you. Because of you I have been able to work and support my family financially. I hope and pray that I will be able to serve you well this year.

With so many conflicting economic, governmental and financial forces in place right now, I often feel anxious. But here is what I try to remember…”Cast your cares on the Lord and he will sustain you; He will never let the righteous fall” Psalm 55:22. I hope you do too.


God bless you,


P.S.—As I have mentioned, I use a lot of very good resources. Here’s why:

A wise man will hear and increase in learning, and a man of understanding will acquire wise counsel. Proverbs 1:5

Where there is no guidance, the people fall, but in abundance of counselors there is victory. Proverbs 11:14

The way of a fool is right in his own eyes, but a wise man is he who listens to counsel. Proverbs 12:15


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