2013 was a year in which all eyes were on our nation’s capital. We began the year on the cusp of going over the fiscal cliff. We endured the sequester, the beginning of the Fed QE taper, and even a government shutdown. Through it all, the markets continued their ascent up the proverbial “wall of worry” on their way to delivering not just positive returns, but numbers that exceeded historical averages by double or more. One thing is clear: the goings-on in our nation’s capital might make for steamy headlines and talk show fodder, but bear little value in predicting stock market returns.
What’s remarkable about the 2013 stock market is not the 30 plus percent returns, although it’s certainly remarkable. In fact, 2013 delivered the highest returns for the S&P 500 since 1997, and the 13th highest calendar year going back to 1926. What was truly notable is how steady the ascent was.
The largest drawdown in the S&P 500 was 5.76%, when the index peaked at 1,669.16 on May 21, and bottomed out at 1,573.09 on June 24. In contrast, the road to 33.36% returns in 1997 included a drawdown of 9.63%, subsequent ascent to new highs, then sliding another 10.80% before finishing the year strong.
Whether ‘tis Nobler…
The Nobel prize in Economics was awarded to two economists with very different perspectives on financial market pricing. Eugene Fama is known as the father of modern economics. He originated and refined the Efficient Market Hypothesis, which states that markets reflect all currently available information. His theories support the belief that outside of luck, it is not possible for someone to consistently outperform the market in the long run through market timing and active stock picking. And even luck runs out eventually. (Disclosure: Eugene Fama is a Board Member of Dimensional Fund Advisors, our first choice for equity mutual funds.) Robert Shiller is known for his analysis leading to the identification of asset mispricing, most notably calling stock or real estate market bubbles.
Perhaps Shiller’s Nobel prize gave the craft of bubble hunting more academic gravitas. Or perhaps it’s our natural behavior to expect recent experiences to repeat themselves. This generation of investors experienced the tech boom and bust, and less than a decade later, the housing and resulting credit bubble. Naturally, they believe, another bubble must be around the corner.
Whatever the reason, we have become a society of bubble hunters. Anytime prices of anything go up (stocks, real estate, bonds, commodities) analysts, gurus and members of the media begin to question whether or not we are in another bubble. It’s contrarianism run amok. Just a thought: if everyone is a contrarian, to whom are they contrary? A search on the Economist magazine website for the word “bubble” turned up 14,100 results. The same search on the Wall Street Journal website yielded 7,873. Apparently we are in, or have recently experienced, bubbles in not just real estate prices and stock market values, but government bonds, student loans, higher education, bitcoin, the country of China and even nannies. You might say that we’re in a “bubble” bubble!
A Wall Street Journal article in early 2013, by an analyst named Alen Mattich, cautioned investors that the S&P 500 had crossed the 1,500 threshold for the third time in history. The previous two times? March 2000, the height of the tech bubble, and the Spring of 2007, the height of the housing bubble. The author cautions that corporate profits, while strong, were specious due to Fed easing. He also made the case that stock price valuations were expensive relative to long run measures. Notably, he cites the Cyclically-adjusted Price-to-Earnings (aka CAPE) ratio, which is also known as the Shiller P/E, as it was popularized by this year’s Nobel prize co-winner. The author noted that the CAPE ratio was at 22.2, while the average since 1900 is 16.4. Clearly a sign that the market is overvalued and ripe for a fall. What the author didn’t tell you is that other than a brief period in early 2009, the CAPE ratio hasn’t been below 16.4 since early 1991. An investor who avoided the stock market since 1991 would have missed out on tremendous gains.
He concluded by stating “market bullishness and complacency about what policymakers can do are already at uncomfortable highs. They might even be at dangerous ones.”
Of course, it’s easy to pile on the guy now, right? He cautioned about market overvaluation and stated his case for why the market optimists were wrong. Then the market goes up 30%.
Looking forward, we have two Noble Laureates with contrary analyses of capital markets. Which one is correct? One view says that market prices reflect all available information, and that to try and predict bubbles is not cost effective. In essence, diversify your holdings and ride through the “bubbles.” The other view says that bubbles are predicable and that investors can profit by reacting to bubbles. What we do know is that the vast data of actual money invested – Shiller does not have an investment fund to illustrate how he would have used his predictions to manage money – suggests that very few investors in the short run, and next to zero over time, are able to profit from calling bubbles.
At Navigoe, since the beginning in the mid 1990’s, our investment strategy has followed the principles of Nobel Laureate Eugene Fama and many other Nobel Prize winners who have contributed to the combined research that is called Modern Portfolio Theory. Without trying to call any bubbles or pick hot stocks, our investment philosophy has helped you to weather two of the three worst market crashes since the great depression.
2013 Market Summary
2013 delivered positive returns in nearly all major equity asset classes. While U.S. markets led the way, developed International stocks also had a very good year. Emerging Markets was the only major equity group of stocks to finish under water.
Equity risk factors in the U.S. were richly rewarded. The S&P 500, as noted earlier, had its best year since 1997 with a return of 32.39%. Small cap risk was rewarded even further with the Russell 2000 index of small U.S. stocks delivering a return of 38.82%. The Value premium was mixed as the Russell 1000 Value index of large U.S. value stocks had a return very similar to the S&P 500 at 32.53% and the Russell 2000 Value index of small U.S. value stocks trailed the Russell 2000 with a return of 34.52%.
International stocks, continue their recovery from the Euro-crisis and the aftermath of the Japanese tsunami in 2011. The broad measure of large developed International stocks, the EAFE, gained 22.78% in 2013. The small cap and value risk factors were both rewarded as the EAFE Small Cap index gained 26.40% and the EAFE Value index added 24.61%. Small value international stocks led the way as the MSCI World ex-USA Small Cap Value index rose 31.58%.
Emerging Markets stocks struggled in 2013. The MSCI Emerging Markets index slid 2.60% for the year. In most years, a small 2.60% loss would be viewed as fairly trivial. However, it stands out as the anomaly when virtually all other equity asset classes are up 20-30%.
As we begin 2014, markets seem to be starting the year tentatively. We can’t know what we will be saying about 2014 this time next year. One thing we can count on is that whether the news is good or bad, both investors and the media will overreact every step of the way. Of course, with the start of a new year, the prognosticators are out in force, offering their best stock picks, market predictions and technical signals. Some are making bold predictions, like this technical analyst who is predicting a 70% decline over the next two years. Others, like Mr. Mattich from the Wall Street Journal article, above, have tempered their forecasts. He predicts the market will deliver returns in the range of a loss of 10% to a gain of 15-20%. Apparently no longer willing to take a firm stance. (Interesting to note that around 50% of the time the S&P 500 is between –10% and +20%)
Regardless of which prognosticators are right (and some will be), our strategy will be to invest in the continued growth of the global economy as people in all parts of the world produce goods and provide services in a continued desire to improve each of our lives. More importantly, we will remain focused on helping you achieve all of your most important financial goals. The good news is that it doesn’t require predictions or market timing.
All the Best!
Scott A. Leonard, CFP®
Eric S. Toya, CFP®