2014 Outlook and a Soapbox Rant

2014 Outlook
Last year, in the annual outlook notes I went out on a limb and stated that: “We do feel that his year, while volatile, will be positive in the markets (barring any major unforeseeable event).” Apparently I could have gone a little further out on the limb with the S&P 500 ending the year up 29.6% and the Dow Jones Industrial Average up 26.5%. I was very accurate in stating it would be a volatile year. Both the Dow Jones Industrial Average and the S&P 500 went through three different corrections of 5% or more. The historical average length of time between these types of corrections is 7.6 months. The market remained very nervous throughout the year as Fed Chairman Bernanke, Washington, Health Care costs, and corporate earnings all stayed on the news 24/7. What will we see in 2014? While I don’t believe in crystal balls, I again have a list of areas I believe should be at the top of our watch list for the year. Some of them the media will do a fine job of keeping in front of us on a constant basis, others I will watch and try to keep you updated in my commentaries throughout the year.

Margin, Earnings, and Bears…Oh my!
I really could not resist using that as my headline for this section. It just fit too well. Many of the economists and market prognosticators that I read on a regular basis have been discussing this triple threat for the last year. I definitely see it as a finger of instability, but, as with all of these things, there is no way to time exactly when it might reach a critical point and collapse. I am watching charts closely and will be ready should it show signs of reaching critical mass. So, what is the story behind this triple threat exactly? It all comes down to the Federal Reserve and historical patterns. The Federal Reserve’s current 0% lending rate has been in place since December of 2008. That is why the media and investors in general have been so focused on the Fed’s meetings and change in leadership with the ending of Chairman Ben Bernanke’s term. With the Fed essentially flooding the system with liquidity (which actually hasn’t seeped out to the economy as much yet) investors have driven up market valuations (as measured by Price to Earnings, or P/E ratios) to highs.

Here is the critical information. From January 1, 2012 through January 17, 2014 the S&P 500 returned 32%, excluding dividends. During that same time frame, real earnings grew by less than 8%. The trailing 12-month price-to-earnings multiple has expanded by nearly 30% from 12.8x to 17.3x. The Shiller P/E metric, when compared to the S&P 500, is at levels last seen near market tops reached in 2000 and 2007. These high levels signal to me a sentiment driven market, which comes into our rule of “Beware the crowd at extremes.” Corporations do seem to feel that sales will pick up in 2014 given the major increase in inventories in the 3rd and 4th quarters of 2013. That could help boost that earnings number, but so far forward guidance has not moved the needle in terms of expected earnings growth. Corporations are also enjoying record high profit margins that are 70% above their historical norms. With revenues rising at a slower pace, the concern is that if margin dips, earnings will not show the growth that analysts are forecasting. Many feel that the markets will return back to historical movements and there is a lot of data to back that viewpoint. Bulls look to the tightening that corporations conducted after 2008’s recession and the extremely low inflation rate to say that these levels are supportable. These high profits are supporting higher valuations in stocks.

Finally, we tend to roll through a bear market once every 3.8 years. We have gone along in our current bull market (I use the definition of a bull market as one that has not seen a greater than 15% correction) for 4.6 years. History is telling us it is time for a correction. The three of these areas combined lead me to believe we are in for a 15-20% correction. Does that mean we need to sell now and run for the hills? NO! It just means I am going to be extra careful this year to protect the profits we gained in 2013. Should the markets have another up year, like many of the analysts I follow are predicting, we will do our best to participate.

However, if during the year we begin to see a correction (we are kind of seeing one as of my writing of this commentary) I will exercise caution so that we do not participate in all of the downside. There are a number of technical indicators that I watch closely to try to see the signals of a potential drop. On the macroeconomic side there are a few other things I am watching that can potentially suck the wind out of the sails of the optimists or continue pushing them ahead.

Cash
There are three sides to the cash story that could mean good news for the markets. First, Investors (both individual and institutional) are sitting on quite a bit of cash. As of January 23rd $2.707 trillion was sitting in money market funds which were paying an average yield of .01 percent. Despite the volatility in both the fixed income and equity markets, some of that money will find its way back into the markets. Investors can’t lose money to inflation for too long before it will be time to add risk for some yield and jump back in. Second, non-financial U.S. corporations are sitting on $1.76 trillion in cash. Considering Apple owns nearly 10% of cash, this wealth is not widespread, but as business investment increases the markets could benefit. Of course, a lot of this cash is tied up to balance out some leverage, so not all of it can go into investment or shareholder returns. It is, however, comforting to know that corporations are not as likely to be caught as terribly unawares as they were in 2008.

Finally, as it relates to the velocity of money, it will continue to be important to watch the velocity of money levels to see if the unprecedented amount of money the Fed has been pumping into the economy will actually get out and we see the inflation the Fed has been shooting for over the last several years.

Overseas 
Overseas markets will be very interesting to watch this year. Central banks are playing a key role in the growth prospects all over the world. I thought that Riverfront Investment Group did a good job of summarizing a few of the key countries in their 2014 Outlook. Here are their comments by country: “Japan is in the early innings of engaging in modern history’s most aggressive quantitative easing (QE) program, and the country ahs been responding. Whereas QE has so far failed to spur bank lending in the US, Japan’s banks have used the excess reserves provided by QE to fuel much faster loan growth. Japan’s economy is strengthening and finally exiting deflation – a ‘poster child’ for QE, in our opinion.” I would add here that of the “three arrows” that Prime Minister Shinzo Abe outlined the third, and most important to long-term growth, has yet to be released. I think investors will react in a big way, either positively or negatively, depending on that release.

“Europe: While its balance sheet hasn’t recently expanded, ECB intervention with long-term refinancing operations (LTROs) has significantly dropped funding rates, helping to bring about a nascent economic recovery. Financial conditions suggest a continued easing bias, in our view.” “China displays strong current account positioning, but we believe financial conditions are generally tightening; municipal credit growth and asset inflation in key sectors such as housing may limit policy flexibility.” “India: New central bank governor Rajan, a widely respected economist, is suggesting the use of consumer price inflation as a main guide for monetary policy going forward. This could lead to continued rate hikes in India (the country had two hikes since Rajan took over a few months ago), but trade deficits have narrowed as the rupee has weakened, a trend to watch for potential signs of improvement.” In general we will continue to see emerging markets try to battle their way back against the inflationary policies of developed markets. Despite their oversold nature, which does put them on my watch list for opportunities, I don’t see them having a better year this year than developed markets.

Conclusion 
While you have probably seen a lot of reports and numbers on “As goes January so goes the year.” I will say that the winner of the super bowl has a greater predicting percentage than this adage when January is a down month. I think a better thing to do this year, as it comes to managing your investments, is keep an eye on the macroeconomic news but focus on our holdings in both a fundamental and technical light. While I am more cautious this year, I don’t believe we will end the year with a negative market return.

Soapbox Rant

I read an article from Stratfor today that brought my mind again to something that really bothers me about my generation and the next.  Please understand that my comments do not fit everyone in either of these generations, but apparently fit the majority.  Just a quick quiz to find out which camp you are in:

What is currently happening in Kiev and how is that affecting global politics?
What is currently happening with Justin Beiber?

What is the current standing of the debt ceiling debates here in the U.S.?
What did your favorite celebrity do for valentines day?

The Federal Reserve has begun to taper its asset purchases, how is that going to affect your bank?
How many of the top contestants of American Idol can you name?

Hopefully you have understood the general direction of my rant.  Why are we so focused on celebrity and reality tv over what is truly important?  I think there are a number of answers to that and none of them are appealing.  One option, in particular, bothers me.  How much does the media play in directing your attention?  Are you digging for information or just watching the major news networks for your news?  Keep in mind these news agencies are in the business to get you to watch.  They will cover what is going to keep you glued to the tv and that apparently is violence, sex, and greed because that is the majority of what I see on the major news hours.  Are you relying on posts from friends on Facebook to keep you up to date, or are you subscribed to news outlets and organizations that will update you on specific areas of importance?

If you are not keeping yourself involved in what is going on around you in the world then please start.  Elections are rolling around and both parties are going to do their best to play off the general ignorance of voters to prove their points.  Don't be fooled and know what you are voting for.