2013: Low Yield, High Return; High Yield, Low Return

Posted on January 10, 2014 by David Laidlaw

The equity market finished 2013 as forcefully as it started the year. The S&P 500 increased 32.4% over the calendar year including dividends, producing the best annual return since 1997 when it was up by 33.4%. Stocks have advanced by more than 53% over the past 2 years and 128% since the financial crisis ended in early 2009. This recovery in valuation has been especially impressive given how close the financial system came to collapsing five years ago as almost all of the major domestic and international banks were insolvent before capital injections from governments.

Aside from the remarkable returns, the market also rose throughout the year without any volatility. The biggest decline occurred between May 21st and June 24th when the market lost 5.76%. This calmness was reminiscent of the 1990s, even though the fundamentals underpinning the market’s rise are much shakier today.

Bonds performed poorly as interest rates rose throughout the year. The yield on the 10-year US Treasury Note began the year at 1.8% and is now yielding roughly 3.0%. Longer duration bonds, such as Inflation Protected Securities and certain municipal issues, suffered the steepest declines in price. The rise in interest rates stems from the Federal Reserve’s stated policy to reduce its bond-buying program. Throughout the year, the Fed has been purchasing $85 billion per month in longer-dated US Treasuries and Mortgage-backed securities. In May, Federal Reserve Chairman Ben Bernanke signaled that this stimulative policy would end. The Federal Reserve then finally announced in December that it would begin reducing its purchases to $75 billion per month starting this January.

A market commentator on Bloomberg radio correctly predicted that the Fed would announce the beginning of the tapering program given that the chair will pass from Ben Bernanke to Janet Yellen. His reasoning was that since Bernanke was the one who embarked on these extraordinary easing measures, Bernanke would have felt compelled to begin the process of exiting the stimulative measures on his watch. The first tapering step is very limited, but the direction is promising.

Aside from bonds, stocks that provide high dividend yields also performed poorly. The chart on the first page of this commentary shows one-year returns of various baskets of stocks grouped by dividend yields. Stocks that did not pay dividends produced average returns of almost 50%, while those with the largest dividends (5% and above) returned “only” 13-14%. High-dividend stocks—such as those found in the utility and real estate investment trust (REIT) sectors—serve as bond proxies for certain investors. As interest rates rose, investors most likely rotated out of these sectors into bonds to benefit from higher yields or growth stocks to benefit from positive momentum. This underperformance represents a dramatic change from prior years during which dividend stocks performed very well.

We expect interest rates to continue rising from these levels. Interest rates can best be conceptualized as the price to rent/ borrow money. As with all price levels, rates are determined by the intersection of supply and demand. Demand for money from the world economy has been growing at a fairly slow rate over the past few years. However, the supply of money created by the Federal Reserve and other central banks (especially Japan’s) has grown very rapidly. This increase in supply has kept rates low during the recovery from the financial crisis. As the central banks reverse course and grow the money supply at a lower rate, interest rates will rise given muted demand. If rates do rise, bonds will perform poorly, but eventually offer stiffer competition to stocks for the investors’ assets.

The economy has turned a corner given momentum within job creation, housing and manufacturing. The US economy is producing roughly 200,000 jobs per month and the unemployment rate has fallen to 7%, which is still elevated, but moving in the right direction. Housing prices are roughly 14% above last year’s levels even though mortgage rates have risen. Finally, the manufacturing sector of the economy is also experiencing very favorable conditions. Demand for automobiles is back at about 15-16 million cars per year, approaching pre-crisis levels without excessive financial incentives. The Manufacturing Purchasing Managers Index (PMI) numbers for the second half of 2013 averaged over 55 compared to 51 for the first half of the year. Readings above 50 suggest expansion and this change implies growth at an accelerating rate. Even though manufacturing is a smaller part of the economy compared to the past given advances in efficiencies, these survey numbers are still impressive.

While these economic indicators point to higher earnings for stocks, we are concerned about future returns for two reason. The first involves valuation since stocks are trading for much higher prices and thus producing less cash flow per dollar of investment. The second reason for concern is behavioral.

We believe stocks are fully valued and that future returns will be much lower than experienced over the past couple of years. Much more of the gains from the market have come from increased valuations than earnings growth. As noted above, the S&P 500 increased 32.4% over the past year, while earnings only increased by 5.6%. Therefore, the majority of the increases in stock prices resulted from the market paying more for each dollar of earnings.

High returns combined with low levels of volatility produces complacency in the minds of both individual and institutional investors. Investors have allocated additional funds to stocks since stocks have produced exceptional returns without any appreciable corrections over the past couple of years. The extreme stress of equity losses experienced in 2008 and early 2009 has faded from the memories of many investors. Even though there is no way to validate the following assertion, I believe that many investors are too aggressively invested in equities relative to their risk tolerances. Pension plans have overinvested to meet their actuarial assumptions and individuals have probably done the same to catch-up on their retirement savings. We do not know where the next shock will come from, but expect it will catch many investors unaware and cause a reexamination of the amount they have invested in risky assets.