China Ripple Effect

We mentioned in our recent Q1 investment commentary that we believed, moving into early 2014, the risk of a market pull-back or correction had increased for a number of reasons: 1) the market’s extraordinary gain in 2013, 2) concerns over initiation of Federal Reserve taper, 3) concerns over slower growth in China, 4) divergences in certain technical market indicators, 5) having gone over two years without a correction of 10% or more, which is about twice the statistical norm.

Over the past seven trading sessions, the market measured by the S&P500 has declined about 3.5%. The reason? China. Investors have become more concerned that growth in China may be slower than previously expected. This has a potential “ripple effect” particularly to emerging market economies which are more heavily dependent economically on China. We believe these issues will prove transitory, or an “adjustment”, in the overall global growth outlook, and should not have too great an impact on U.S. companies. If the Chinese economy does slow to a degree much greater than expected, it could have some impact on U.S. corporate earnings to a greater degree than we now expect.

With respect to our investment strategy, we continue to remain more heavily weighted in U.S. stocks. In international stocks, we do have exposure to EAFE, a broad international index, but we are underweighted in emerging markets equities. We believe fundamentals for U.S. stocks remain generally positive: earnings growth is expected to accelerate in 2014; U.S. corporations continue to hold record levels of cash; M&A activity should remain strong in 2014; inflation remains subdued. Positive investor sentiment has become somewhat more of a concern but at 14.8x 2014 earnings, valuation is not excessive.

As we always do, we are keeping a close eye on developments in China and emerging markets.  We  have not changed our view that the risk of a 10% or greater pullback in the U.S. stock market has increased. However, we would view such a correction as a normal “adjustment” within a longer term bull market, and as of now, we are taking no specific actions to change investment allocations or strategy. As a reminder, an important way in which we aim to buffer client portfolios from market volatility is through our strategy of asset class diversification. This diversification helps to reduce sensitivity to changes in equity prices and, thereby, reduce portfolio volatility with the ultimate long-term goal of improved risk adjusted return.

Notes From Our First Quarter Investment Strategy Meeting

We held our first quarter investment strategy meeting on December 30, 2013. 2013 was an extraordinary year for the stock market reflected in a total return for the S&P500 of about 30%. There are only a handful of years in the past 60 which have seen gains of this magnitude. The stock market overcame an amazingly high “wall of worry” in 2013. These worries included things such as the debt ceiling, the Syrian conflict, Federal Reserve policy, slowing corporate earnings, slowing growth in China, and continued government policy uncertainty, to name but a few.  

What drove the market up this “wall of worry”? Several factors: capital seeking higher return alternatives to bonds; improving outlook for the economy and corporate earnings; and “financial engineering”. With regard to this last point, the current low cost of debt is providing an opportunity for corporations and investors to improve their investment returns by using low cost debt to make acquisitions and buy backs shares. This is similar to what occurred in the 1980s and we believe will provide a positive backdrop for stocks in 2014.  

We remain positive on the outlook for stocks. Fundamentals for equities, particularly the economy and corporate earnings, remain generally positive. Of increasing concern, however, is valuation. With the S&P500 now trading at about 15 times 2014 earnings, stocks are no longer “cheap”. This raises a bit of a cautionary flag that a) valuation may not be the driver of stocks prices it has been heretofore and b) market risk has increased. Another concern is the fact that the market has not had more than a 10% correction since mid-2011, which implies the odds of a correction in 2014 have increased.

The investor “conundrum” continues for the bond market. We believe returns on bonds, which have averaged 5-6% over the past several decades, will be considerably lower going forward.  We believe the secular trend in interest rates is now up, as opposed to the last thirty years, in which the secular trend had been down. We expect this new secular trend will keep pressure on bond returns. We expect interest rates will rise in 2014 in a gradual but steady fashion.

With respect to portfolio changes following the meeting, we further increased exposure to large and mid-cap stocks. We believe quality, dividend-paying stocks continue to offer value and attractive risk/reward. We further increased exposure to technology stocks as we view the sector as undervalued. We reduced exposure to REITs but increased our exposure to energy. Within bonds, the most notable change was the elimination of our position in preferred stocks and the addition of a position in high-yield corporate bonds as a way of reducing duration while maintaining a high income stream. We also raised our exposure to short-term bonds to reduce duration and interest rate risk.