2013 is in the Books- What can we do for an Encore?

2013 turned out to be a banner year for equity investors. As the nearby chart illustrates, most domestic equity indexes were up by 30% or more, and international developed indexes by 20% or more, while developing market indexes mostly had slightly negative returns. Bonds had one of the worst years in decades, with virtually all fixed-income indexes showing negative returns. So-called inflation protection strategies performed very poorly. Commodities and REITs both had negative returns. Fortunately, at Coldstream, we have been believers in MLPs and global infrastructure investments, both of which had stellar returns for the year. Overall, investors fared better in 2013 than expected by experts.

Economic Outlook for 2014

So, where do we go from here? We expect economic growth to be broader and stronger yet remain somewhat constrained worldwide. Bill Gross, managing director and co-CIO of PIMCO says 2% real growth is the new normal. However, macroeconomic risks are diminishing as economies improve. This improvement should help to reduce fear and strengthen confidence in businesses and investors. In the US, fiscal drag, induced by government-led deficit reduction strategies (higher taxes, lower spending), should prove to be less of a headwind to growth in 2014.  Japan and Europe, in particular, appear to be poised for better growth. We expect to finally see a pick-up in capital spending in the U.S. as well.

Fed tapering will likely be slow and measured with U.S. and global monetary policy geared toward stimulating growth. As a result, we see interest rates moving higher throughout the year but do not believe they will become a significant headwind for equities. Rather, we believe the U.S. equity markets will continue to grind higher despite higher interest rates.

There have been 17 times since 1926 in which S&P price returns have exceeded 25%. On average the US market, as measured by the S&P 500, has been up 6% in the calendar year following such stellar performance. However, outside the U.S. we are optimistic about better earnings in 2014 and this, coupled with lower valuations on international stocks, provides investors an opportunity to obtain better returns on foreign investments than they might in the US markets.

Source: Strategas Research

Investor Sentiment and Future Projections

To summarize, as investors we are encouraged about the prospects for 2014. While domestic stocks are no longer dramatically undervalued, neither are they overvalued. One long standing investment tenet is that inflation plus the S&P 500’s Price-to-Earnings ratio (PE) should equal 20. If inflation stays contained at or near the current 2% area then PE’s on the S&P 500 could be around 18. Using an 18 PE times our expected 2014 S&P earnings of $115-$120 would mean the S&P could reach 2100. If that bromide holds, another 8-12% advance in the S&P in 2014 would not be much of a stretch. In the short-run we are long overdue for 5-10% correction. But, we would expect any correction to be followed by further advances.

We at Coldstream would like to wish you a most happy and healthy 2014.