One of the purposes of our quarterly market letters is to help clients better understand our investment discipline and how we implement it. After all, you work hard to accumulate financial assets to achieve your goals and to maintain your desired lifestyle in retirement. You entrust Dumont & Blake to prudently manage and advise you with regard to those financial assets. As we have said before, investment management is an evolving process. It is important that the process be reviewed and adapted to changes in the current and future market environments. The following is a brief synopsis of how we have been doing just that and what we are expecting for the upcoming year.
Through our discussions with you about your lifestyle and financial goals, we set a long-term or average asset allocation for each client. Depending on the market environment, the current allocation can vary up or down from the average. When the stock market declined in 2008-2009, our equity allocations were lower than the average. As the market started to climb in the middle part of 2009 our portfolio equity allocation was average and above. In 2011, we saw an opportunity in large cap stocks with enough cash on the balance sheets to comfortably support their dividends. We saw this as a great entry point for not only large caps, but to also increase our positions in equities in general. Over the next two years, the stock market continued to rise with the S&P gaining 16% for 2012 and 32.4% for 2013.
In 2008-2009 our fixed income allocation was at its highest level. With yields on 10 year bonds around 5%, we weren’t hesitant to lock in those rates. Over the next four years we would see the yield on the 10 year U.S. Treasury come down to 1.42%. The bond portion of your portfolios buoyed the value of your accounts when the stock market was severely depressed. However, where the bonds really benefited was over the next few years, and as the stock market slowly rebounded any distributions could come out of the bond portfolio allowing the equities to continue to grow. The bottom line is we had less exposure to stocks in a bad market and a higher exposure in a good market.
As we wrote about in the past letters, we had to adapt to extremely low interest rates. We did so by diverting some of the amount normally allocated solely to fixed income to higher dividend paying stocks and high yield bonds. This move entailed higher risk than owning higher quality bonds, so to offset some of the risk we chose to hold higher than average cash balances.
Going into 2014 we still see upside opportunities in the stock market. The market is currently selling at 17 times earnings. While not cheap, it appears to be fairly valued with ample room for further upside. Companies are still sitting on tremendous amounts of cash and earnings continue to grow. Dividends are well covered and increasing. Although stocks may be fairly priced on an absolute basis, relative to other investment choices equities still appear very attractive. Money market rates and shorter term CDs still yield just fractions and a 10 Year U.S. Treasury note yields just 2.88%. While we are not looking for stock market returns like the last two years, the environment still lends itself to a positive return by year end. If the market gets more expensive and interest rates rise we will start to reduce our equity allocation closer to the average long-term target percentage.
As we said earlier, investment management is a process. We have a process and a discipline that we consistently follow. You should know that through the normal fluctuations in the financial markets, your portfolio is being prudently managed and continuously monitored. We appreciate the confidence you have placed in Dumont & Blake and will do everything we can to provide you with the lifestyle you deserve.
The last quarter continued its upward trajectory and domestic market equities finished a banner 2013 with a trumpet blast. After the 10.5% advance in the fourth quarter, the S&P 500 Index posted a 32.4% gain for the year, which was its best annual return since 1997, closing the year at an all-time high. More than 450 of the 500 stocks in the S&P had positive returns, and the index traded up for the entire year, never being down, on a year-to-date basis, for any day in 2013. The Dow Jones Industrial Average, the oldest and most watched index in the world, increased by 10.2% for the quarter and 29.7% for the year. While slightly lagging during the last three months with an 8.7% return, the Russell 2000 Index (comprised of small and medium size companies) managed to increase 38.3% for the year. The NASDAQ Composite Index was the winner, both for the fourth quarter and the year, posting 11.1% and 40.2% returns respectively. These returns substantially exceeded last year’s “expert predictions” and even perennial bulls were somewhat surprised by the robustness of the U.S. equity markets. All sectors of the domestic economy advanced by double digits during the year and, most importantly, the pro-cyclical Consumer Discretionary and Industrials sectors once again outperformed the more defensive Staples and Utilities. Even the developed markets worldwide joined the U.S. equities – to a certain extent. The MSCI EAFE Index rose 5.4% for the quarter and 19.4% for the year.
Other asset classes did not fare as well. The fixed income market suffered one of the worst years in its history, losing ground for only the third time in 28 years. The Barclays Capital Aggregate Total Return Bond Index lost 2.0% in 2013, while longer 20-Year U.S. Treasuries were down by 13.9%. The interest rates on the 10-Year U.S. Treasuries fluctuated around 2.5% for the most of the quarter, rising to 3.0% on the last day of the year. Gold lost 28%, having its worst year since 1981.
2013 has been a remarkable year not only because of the stellar performance put in by the stock market, but economic and, more strikingly, political developments, which should have had a profound negative influence on the stock market, seemed not to have mattered to investors. As the last quarter of 2013 began, the charging bull market effortlessly overcame two substantial challenges – a partial U.S. government shutdown that lasted over two weeks and the threat of a U.S. debt default. While the political hysteria surrounding these events might have sold newspapers, the impact of diminished government spending on the overall economy was tiny compared with the public sector impact, and the stock market appropriately took the political rhetoric as “much ado about nothing”. Instead, the market focused on the encouraging statistics and disregarded the tenacious pessimistic voices planting the negative spin on each part of the incoming data.
The latest real GDP growth for the third quarter 2013 came in stronger than expected, revised up to 4.1% annualized compared to the previous 3.6% and 2.8% advance estimates and 2.5% in the second quarter. While it is true that the upward revisions of real GDP growth were due to inventories, as the pessimists pointed out, even without inventories the real GDP was still up over 2%. Both the service and manufacturing sectors of our domestic economy expanded according to the Institute for Supply Managers, with the service sector expanding for the 47th consecutive month and industrial production reaching a pre-recession peak.
The unemployment data persistently improved throughout the year and the last jobs report of 2013 was one of the best of the preceding few years. Nonfarm payroll added 203,000 new jobs, wages rose, total hours worked increased, and the unemployment rate finally sank to 7%. While almost 40% of the job growth came from the government sector, it was duly noted by investors that this report, based on a survey of American households, followed the shut-down and then re-opening of a number of government agencies.
The Consumer Confidence results released by the University of Michigan in December showed an increase of 6.1 points to 82.5%, and automakers reported they sold cars and light trucks at the fastest pace since 2007. The federal budget deficit dropped almost $900 billion from its all-time high in February 2010 with the help of growing tax revenues and over four years of zero increases in government spending. So, in spite of Keynesian fears that the partial government shutdown and the sequestration were supposed to hurt the economy, the reality once again proved otherwise. Higher tax rates are not necessary to boost revenues; we just need a growing economy.
On December 18th, after its last 2013 meeting, the Federal Reserve announced it will now be purchasing $75 billion of bonds monthly, as opposed to the $85 billion per month it bought in 2013. We all remember a huge negative reaction by the equity markets when Federal Reserve Chairman Ben Bernanke whispered about the possibility of tapering in May of last year. However, this long-awaited Federal Reserve’s December tapering announcement pleased, not terrified, Wall Street. The Dow surged up 292 points that day as the Fed’s statement removed the uncertainty from the U.S. monetary policy and sent a clear signal of a macroeconomic consensus that the domestic economic growth is likely to be sustainable.
As we start a new year, there are no major signs of imminent gloom; however, it would be foolish to discount two factors that bear watching in 2014 – stock valuations and investor sentiment. After five and a half years of rising stock prices, U.S. equities can no longer be considered inexpensive, but the valuations are not yet overly troubling and the market is not stretched, based on the historic mean. It is also quite possible that the valuations will continue to expand, as the yield curve remains steep. With long rates much higher than the short rates, which we observe today and are likely to maintain for the next year, we see better growth on the horizon. Low inflation supports higher valuations by making earnings more valuable – just like our earnings as workers are worth more when the price of goods takes less of a bite out of them. Moreover, equities still look attractive compared to the prospective returns on savings accounts and long term bonds, as yields, while higher than a year ago, could rise further as the Federal Reserve continues to reduce the quantitative easing.
We agree it would be overly optimistic to expect 2014 market returns to match or exceed 2013. After all, we have not seen a meaningful market correction since 2011. But if history is of any guide, great years are often followed by good years. Since 1945, the S&P 500 Index gained 20% or more 21 times and the average market performance for all 21 of the following years was a gain of 10%, and based on information available today, we would view any correction as a buying opportunity.
Dumont & Blake Investment Advisors, LLC
December 31, 2013