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Year-End Wrap-Up and Thoughts on the Year Ahead

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With a Federal Reserve-induced wind at its back, the US stock market sailed into year-end to close out 2013 with an outstanding performance. In fact, US stocks had their strongest year since 1997, with the S&P 500 closing the year right at its all-time high. Over 90% of the companies in the index had positive returns for the year, with about half the gains for the year coming in the last quarter.

In the last quarter of the year, the most aggressive stocks in the index moved well ahead of the defensive stocks, demonstrating investor’s general penchant for assuming risk based upon their belief that the Federal Reserve will continue printing money, and that new money will flow into the stock market pushing stock prices even higher.

Other asset classes faired much worse. Foreign stocks significantly under-performed the US markets, with a blended return of 8%. The Aggregate Bond Index lost nearly -3%, its first loss in 14 years. Gold lost -28%, which was its worst year in nearly a quarter of a century. Given the general view with investors that the Federal Reserve can print money forever without inflation being a threat, Gold was definitely the whipping-boy of the 2013 investment markets.

In looking at the market’s sector performance for 2013 we see that Consumer Discretionary, Healthcare, Industrials, and Financials were the leaders, each up by more than 30%. Following closely behind were Technology, Consumer Staples, and Energy, which were each up more than 20%. At the bottom were defensive sectors Materials, Utilities and Telecom, which were up less than 10%.

Fully diversified portfolios that include all asset classes for risk management purposes were positively influenced by the US component but held back by the allocations to other asset classes. However, in reviewing historical asset class performance, this is the first time since 1997 and 1998 that the US markets have been the top performing asset class. Having a diversified portfolio, over the long-term, provides for much better performance than an S&P 500 centric portfolio. It allows investors to spread the risk of financial loss over a wider array of asset classes, it ensures investors include the top performing asset class in their mix, and it provides for a more consistent risk-adjusted return over the long-term.

Valuations have been pushed toward historic highs, meaning that the US stock market is expensive compared to other asset classes, with the exception of bonds that have been on a 30-year bull market. In 2013, the riskiest stocks with little or no earnings pushed the index to its highs as Federal Reserve policy encouraged investors to assume ever-greater levels of risk.

The riskiest stocks have had a rocky beginning to 2014, but that does not mean we have seen investors get religion. We saw a similar Federal Reserve policy push the US housing market higher before greed brought it to a crashing halt – the question we all need to ponder is whether the same thing can happen to the stock market.

As we look to 2014, even though we have started the year with several down days in a row, investors are still as a whole very bullish on the stock market. As long as the Federal Reserve is printing money, the US economy is growing slowly, interest rates remain low, and inflation is not a concern, the stock market should continue to move higher as investors are in the mood to assume risk.

Unfortunately, corporate earnings are projected to grow less this year than last and the expansion of market multiple (i.e., the ratio of stock prices to company earnings – or how many years of earnings an investor willing to pay for a share of stock) is unlikely to expand at the same rate as 2013, so we probably will not see the same rate of return in 2014 as in 2013. However, 1997’s 33% return was followed by 1998’s 28% return, so anything is possible when you are dealing with an extraneous market force like the Federal Reserve’s money printing influencing investor psychology.

At some point, earnings and valuation will matter to investors and the stock market will go down. Much like a housing market that pushed home prices higher based upon little fundamental relationship with value, the stock market will at some point realign with mean valuations either through a correction or by moving into a trading range that will keep prices flat for a period of time until earnings catch up.

Until then, you have to…

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