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.