Posted by David Tillson 2014 First Quarter 

 For the first quarter of 2014, stocks continued their upward rise, albeit at a more muted pace than in 2013. Our expectation has been and continues to be that the market’s 2014 full year performance will most likely fall in the 8-10% range and that its complexion, like last year’s, will continue to favor actively managed portfolios that concentrate on the fundamentals of companies. However, we are well aware that some investors may feel an urge to lock in gains at the first sign of trouble or increasing volatility. Our last quarterly letter’s closing paragraph asked: Should we sell now? Part of our answer was that as long as you understand that you are on a roller coaster, you should sit back and enjoy the ride. April has reminded us that we are still buckled into that roller coaster. 

The list of things to worry about is still quite long: Ukraine/Russia, China’s slowing economy, potential Fed tightening and rising interest rates, the size of our Federal debt, unemployment and lack of growth in wages, to name only a few. No one knows how, or even if, these worries will actually play out, but as people focus on what might happen, the financial markets are impacted both negatively and positively. And if the imagined result is bad, stock prices usually decline, at least for a short time. But as readers of our past letters know by now, a world without worries is a world about to be hit with a nasty surprise. 

Our overall outlook remains quite positive even though the geopolitical landscape is a little unsettled at the moment. Russia’s saber rattling on Ukraine’s border has the potential to create considerable turmoil, but we doubt that it will derail the ongoing strengthening of the world economy. World politics have always been filled with uncertainty but most of the time détente prevails resulting in little negative impact on the financial markets. Slowing growth in China has been another area for worry as people remember that it was essentially China’s very strong growth in 2008-2010 that kept the world economy going while the developing countries faced the financial melt-down. Now five years later, the U.S. and Eurozone are stronger and dependence on China has been reduced. Furthermore, a slowing growth rate is not necessarily bad. To keep it in perspective, if China’s $9.2 trillion economy grows only 7.3% in 2014, the resulting $670 billion increase in GDP is the same as an 11% increase in its 2010 economy. Its slower growth will still be substantially additive to the world’s economy and as it has matured, China has been evolving into a better trading partner that will allow the U.S. to export more to them than just our debt. A majority of the world’s economies are operating at least satisfactorily and most major central banks are using various quantitative easing measures to promote growth and inflation.

Conditions in the U.S. are ripe for an accelerating economy. The Fed is still leaning toward a dovish stance while they taper their bond buying program. Many of the problems of the past few years have corrected and some have even turned positive. As we have mentioned before, time is a great healer and balancer. Housing has rebounded in most of the country, unemployment has declined and the U.S. is experiencing an energy boom. Banks are in very strong shape, the Federal deficit has declined to less than 4% of GDP, and consumers’ balance sheets have to a large extent been repaired. Home ownership rates have declined, but only to historical levels which is an indication that they never should have risen to the 2007-08 heights in the first place. A little more disturbing is that the labor force participation rate has declined to a level last seen in 1978 which can only partially be explained by the baby boomer generation beginning to retire. A better explanation is that many people have simply become discouraged and stopped looking for work. In order to have a lasting recovery with rising personal income, the U.S. must find the path to higher job creation. The world moves in cycles, and as we experienced after past stock market bubbles (Roaring 20’s and the Nifty-Fifty of the 1960’s), the balance of power has shifted dramatically from risk-taking capitalists who create jobs to government regulators who are charged with ensuring that the past mistakes are not repeated. The pendulum swings and it must reach its natural peak of too much regulation before it starts to swing back toward free enterprise. By keeping interest rates low, the Fed is doing their part by trying to encourage risk-taking which will lead to job creation. Regulation, however, must be balanced so that it protects the public but does not completely stifle growth. Our tax code should also be adjusted to stimulate risk-taking, growth and job creation. 

After the late 1970’s, INFLATION was much feared. The Fed became diligent in making sure that it did not return. However, the six year period between 1979 and 1985 was the only time since at least 1790 that rates spiked to double-digit levels. While there are no guarantees, it is unlikely that we will face that type of inflation for decades at least. Deflation is the Fed’s and Europe’s current concern because as Japan has seen, it can be even harder to conquer than inflation. As long as it is controlled, inflation is very positive for economies allowing wages to increase, companies to raise prices, and current debt to be devalued over time. In order to have “good” inflation, a country typically needs both rising wages and rising home prices, rather than just rising commodity and product prices. In the U.S. housing prices have been rising since the meltdown of 2009. Wage growth which has been mired in the 1.5-2.0% area for the past four years is finally showing signs of acceleration. Once this virtuous circle of rising prices, wages, interest rates and spending starts, we will be well on our way to a sustained period of growth. When this happens, it will be a boon for the Federal government which now has $17 trillion of outstanding debt and to savers who will finally be able to earn a reasonable return on their fixed income investments. 

During 2013, the S&P 500 Index earned a 32% total return. As rewarding as that was, it is important to understand where that return came from. Growth in earnings contributed 9% and dividends 2%. The remainder was due to a higher P/E ratio which rose 20% from 13x to over 15x. Our belief that the market will return 8-10% this year is based simply on the following: earnings growth of at least 7%; dividends adding 2%; and no change in the P/E ratio. Since the 1920’s these same components have provided the 10% annualized return experienced by the S&P 500 Index. Earnings have risen at a 7% rate, dividends have provided a 3% yield and the P/E ratio has averaged 15x. As long as inflation is positive, we see no reason to believe that the future will be any different. The chart shows the market’s 5-year rolling returns since 1950 juxtaposed against that positive 10% compound average return. It is clear that exact 10% returns are rare, but this chart also suggests that the market is poised for a period of above the 10% line returns in coming years.