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Proceed with Caution?
Toronto: January 13, 2014
By John Stephenson

After the banner finish to the market last year, the price action on the S&P 500 has so far been somewhat dismal with stocks consolidating and digesting their big advance.  Most of the trading so far this year is coming from fast money hedge funds with big mutual fund investors choosing to sit this round out.  Markets are searching for a direction in the early days of 2014 and there doesn’t seem to be a lot of conviction on the part of investors. 

Adding to the recent skittishness was last week’s payrolls shocker that showed the weakest pace of hiring in three years.  American employers added 74,000 positions last month, a disappointing turn after a four-month stretch over which monthly payroll expansion averaged gains of 213,500.  But for now, investors seem to have decided that the most recent payrolls report was more confusing than disappointing with many believing that the poor results were either due to weather or a statistical fluke rather than a sign of underlying economic weakness.

The market’s performance in 2013 was impressive with all ten S&P 500 sectors posting gains.  Cyclical sectors were the place to be last year, while defensive sectors lagged. Consumer discretionary soared 41%, while Health Care was up 39%, followed closely by Industrials (+38%), with Financials finishing up 33% on the year. 

The good news wasn’t limited to America as Germany’s DAX index soared 26% in 2013, while Japan’s Topix rallied 24% in U.S. dollar terms.  But for the emerging markets it was a different story, as Turkey fell 28%, while Indonesia and Brazil slumped 25% and 19% respectively, as higher bond yields and a stronger U.S. dollar took their toll on these markets. The few bright lights in emerging market performance were from China, which eked out a modest gain of 0.4%, while Korea was up just 2.7% and Taiwan finished the year up 6.6%. 

Merger and acquisition activity was strong last year, rising by four percent despite the weakness in mining and energy deals.  The most active sectors for deals were in real estate and telecoms with the average takeover premium hitting a record of 25%. Commodities struggled again in 2013 with precious metals spiraling downward as gold fell 28% and silver tumbled by 36%. 

The strong performance of developed markets in 2013 has some investors beginning to sound the alarm.  Many are suggesting that the strong moves of the market over the last few years is reminiscent of late 1990s tech bubble. Adding fuel to this fire is the release of the minutes of the latest Federal Reserve policy meeting, which show that central bankers too are concerned that financial markets may be entering bubble territory.  It’s getting harder and harder to open a newspaper or turn on the financial news these days without some financial commentator suggesting that a bubble is upon us.

While today’s stock market may not be a bargain, it doesn’t appear to be anything like the overhyped market of 1999-2000.  For starters, retail investors have been sitting out most of this recent rally with equity allocations some 20% below the peak of the late 1990s. There’s no prevailing view by retail investors today that world is being swept up by some irresistible force that makes stock investing a no brainer.  The psychology is very different this time around as investors have witnessed two major bear markets in the past decade as opposed to the late 1990s, which marked a twenty-year run for stocks.

Despite the slow start to 2014, I expect the year to be a pretty good one for equity investors.  I see U.S. 10-year yields hitting 3.5% by year-end, which should help drive fixed income investors toward the market.  The U.S. economy should be able to grow at three percent or more this year, the best performance in a decade, which should bolster sentiment and equity flows.  Falling correlations between assets as the stock market transitions from being policy-led to fundamentally driven will be good news for active managers who have taken a backseat to passive strategies the past few years.

I am favoring developed markets over emerging markets for the next six months or so, as monetary policy and earnings revisions are supportive for these markets.  Investors should continue to overweight cyclical stocks that will benefit from solid economic growth.  For my money, I like the financials, particularly the U.S. money center banks that are increasingly putting to bed their litigation risk and appear to be on solid footing for the first time in a long while.

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