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4th Qtr and 2013 Review

The 4th quarter started with the government shutdown and a failed launch of HealthCare.gov.  To say Americans were frustrated with Washington would be an understatement.  But, in miraculous fashion Democrats and Republicans agreed to a budget deal in mid December.  A working budget along with continued economic improvement gave the Federal Reserve (FED) confidence enough to slow down its stimulus.   All said the stock market ended the year on a positive note, but bonds ended up having their worst performance in 14 years.  As we go into 2014, investors seeing their 401(k)’s and stock accounts grow are excited about the future, but sometimes over-excitement is not a good thing in the market. In this issue of Allgen’s quarterly update we will look at the headwinds of heightened optimism and the probable end of the bond buying policy which could increase short-term volatility.  We’ll also look at the long-term secular bull trend versus other historical bull trends.  Finally we will give you an update to the bond market.

Over-Confidence Creating Complacency

History shows that when average investors collectively become overly bullish it increases the probability that there will be a short-term pull back in the market.  Currently multiple measures of sentiment (VIX, Put-Call Ratio’s, AAII Survey, etc…) are in the “Extreme Optimism” area which is a negative for the market in the short-term.  On the other hand when you look at institutional money, a.k.a. “smart money” such as pensions and endowments, they historically hold a low level of equities which has the potential to create a high level of demand for equities.  We believe the heightened level of optimism could lead to a short-term correction potentially in the first half of the year, but we would view this as a buying opportunity because there is a lot of institutional money underweighted in stocks looking to get into the stock market.

The “Taper” Begins

Going into 2013 most people had never heard the word “Taper” (meaning: gradually decrease) with regard to the market, but by the end of 2013 investors were sick of the overly used term.  In December the FED finally started to taper their $85 billion bond purchases by $10 billion decreasing the monthly amount to $75 billion.  The general consensus is that the FED will continue to decrease the program by $10 billion at every meeting through 2014 assuming the economy doesn’t slow down. This would mean the program would complete near the end the 2014.   If the economy were to accelerate they may wind down the program sooner.  What does this mean for investors? We actually view the FED tapering as a long-term positive but we see increased volatility in the short-term as investors watch to see how the void will be filled.  Some would say that interest rates will need to go higher in order to attract buyers as the FED is no longer buying bonds, but during the last two times (2010 and 2011) that the FED ended its bond buying program interest rates actually went down.  In both of the previous cases the market went down and bonds went up as a flight-to-safety.

A Look at Past Secular Bulls

The word secular, when referring to trends and cycles, means a long-term scale of around 10 to 15+ years.  The three secular bull markets that occurred in the 1900’s (green lines) averaged around 16.7 years (See chart).  If you were to consider 2009 the start of the current bull market it would mean the market is 5 years into a secular bull – only a third of the time frame that secular bulls last on average.  This is not to say there is always smooth sailing in a secular bull market, as evidenced by the October 1987 crash during the 1982-2000 secular bull.  Strictly from a charting perspective, the S&P 500 breaking its long-term resistance of approximately 1570 in March of 2013 increases the probability that we are in a secular bull ending the secular bear that started in 2000 (see chart below).

Source: http://www.macrotrends.net/1319/dow-jones-100-year-historical-chart Source: StockCharts.com

Bond Market Update

2013 was the first down year for bonds since 1999 with the Barclays Aggregate Bond Index being down just over 2% for the year.  Since 1980 it was only the third time that the bond index was negative. The last two times before 2013 when the index was down (1994 down 2.92% and 1999 down 0.82%) the following year had double digit returns.  Although history is usually a good reference, that particular time period (1980 -2013) was accompanied by a long-term downward trending interest rate cycle which is conducive to high bond returns.  As we reported in our 3rd Qtr 2013 market commentary we believe we are starting a long-term upward trending interest rate cycle. In anticipation of this, we have made a shift over the last couple of years to reduce our duration and own more high yield bonds.  Going forward with the bond picture we believe interest rates won’t go up at the pace they went up last year, but we also believe long term total returns for bonds will be much lower than what we experienced over the last 30 years.

Going Forward

We believe stocks will be better positioned than bonds for years to come as the stock market has confirmed its secular bull market status and the bond market faces rising interest rate headwinds. As such, we have slowly increased our stock positions relative to bond positions over 2013.  While we believe current extreme optimism in sentiment and the FED’s reduction in stimulus could lead to short-term volatility, we would view a pull back in the market as a buying opportunity for stocks.  Specifically we would look to increase our mid and small cap U.S. positions to take advantage of the potential strength in the U.S. economy.  While stocks provide growth potential, bonds play a significant role in protecting capital, reducing volatility and providing income.  On the bond side we have shortened maturities, increased corporate and high yield corporate bonds and significantly reduced our long-term U.S. government bonds. We continue to manage risk first in all of our investments, but we have been more actively searching and taking advantage of potential growth opportunities.