2014 MARKET OUTLOOK
by Craig McFadzean & Christopher Crowe, Turn8 Partners
We expect the bull market to continue in 2014 driven by improvement in the global economy and continued market momentum. As usual, the majority of the predictions from analysts are the standard “high single digit, low double digit” return estimate that seem to come out every year, which is not too valuable given the market’s long-term average is roughly 10%. The reality is that the market is more binary, or “barbell-like”, with most returns either being much higher than 10%, or outright negative. Here are some interesting numbers using S&P500 total return data we obtained from Yahoo:
- Over the last 50 Years the index has an average total return just above 10%
- Only 5 years (10% of time) have the returns been close to 10% (i.e., 7% to 13%)
- 11 of the 50 years have provided negative returns (22% of time), and
- 33 of the 50 past years have seen annual returns greater than 20% (66% of time)
There is a strong case for 2014 to be another great year as most of the economic, market, and corporate news supports growth. It’s highly unlikely to see the torrid returns we witnessed in 2013, but still possible to see a return in the high teens. Our base case of an above average year is if everything we are witnessing at the moment doesn’t get derailed, which given today’s environment would likely be an escalating conflict (think Middle East or North Korea), government/politician miscues, or a hard crash in China.
We believe 2014 will be much the same as 2013, but more muted. Momentum will likely cause the longer term trends we’ve been riding to continue, but we are starting 2014 at much higher relative valuations in most developed stock markets. Nerves may be the greatest challenge this year as we expect more volatility in the stock markets and potentially a more significant correction at some point. Bonds will likely be more stable than this past year, but still provide minimal total return.
STOCKS
There are many who are calling for a major correction in stocks, particularly US stocks due to perceived over-valuation, but we just don’t see it happening yet. The popular metric used for valuation is price-to-earnings (P/E ratio) and the graph below shows there is nothing alarming just yet when comparing the current P/E to the long-term average. Compare this to the average P/E during the recession of the early ‘90’s, the tech bubble at the start of the millennium, and the credit crisis of 2008, which was over 25 times.
A lot of the market run up this past year was driven by what is called P/E expansion, which is illustrated in the graph above and means paying a higher price for the same earnings. Taking a look at P/E ratios, we can see that the trend among the markets is a desire to pay more for their share of corporate profits. Looking back at this time last year, most stocks in the S&P commanded a price that was about 13 times the average estimated per-share earnings of its constituents for the year ahead. Today, looking forward, we are seeing the same sample command 15 times estimated 2014 earnings. What does it all mean? Well in simple terms, a higher P/E reflects investors’ confidence in stocks relative to other assets—such as bonds. We expect to see continued expansion this year, plus we also believe we’ll benefit from corporate earnings growth as well. Further support of our optimism is derived from the forecasted growth of the gloal economy, exceeding 2013.
These are just two of the fundamental reasons for our optimism. There are many other reasons markets can have another banner year: Government’s appear as though they will continue their friendly stimulus plans and low rates; the Unemployment rate is declining; The wealth effect of the population can lead to increased consumer spending; And the fact that stocks represent a better long-term investment than bonds. Another item that would boost the markets would be if Emerging Markets got going. They had a tough year and severely underperformed developed stock markets in 2013. It’s tough to get a clear line of sight on their immediate future, but it could be quite something if we see the likes of China and Brazil pick it up.
We don’t expect to be making big changes to our equity models for 2014, and will continue to expand on three themes we initiated in 2013. First, we grew our exposure to developed international markets in 2013 and look to expand on this in 2014. They may appear more risky, but Europe and Japan (in USD terms) also present higher growth potential. Second, we will continue adding to more cyclical areas such as Industrials and Small Caps to go along with our existing overweight to US Healthcare, US Technology, and US Financials, all of which did well in 2013. Finally, our overweight exposure to the US helped in 2013, particularly for our Canadian clients, and we expect this to continue in 2014 because the Canadian economy is lagging that of the US. The three largest sectors in Canada are Financials, Oil, and Mining and all face headwinds. The banks are challenged as personal debt loads continue to escalate while income growth is flat. The US desire to be oil independent could drive the price of oil lower and result in less demand for Canada’s oil sands. Lastly, Mining has been in a funk due to tepid global growth and will likely continue if the current struggles in Emerging Markets don’t improve.
Unlike the last several years where we got off to great starts and struggled through the summer, we expect greater challenges and uncertainty in the first half of this year compared to the second half. Governments generally remain a big reason for market movement due to their manipulation of key economic levers, and the uncertainty it creates. In addition, the transition to Janet Yellen as the head of the Fed in February will cause further uncertainty and a pause in the markets. As a result, we expect a slow start in the first few months of the year, followed by the market returning to a state where corporate earnings drive market growth, which would be a nice change.
BONDS
We’ve written about the trials and tribulations of the bond market in many of our 2013 pieces. In the end, the total return for both the Canadian and the US bond universes lost money for the year, which is not fun for retirees who look to bonds as their “safe” asset class and for income. The struggles began in May when talk of pulling back on quantitative easing (QE) truly began. Market interest rates were shocked higher, which caused bond prices to fall dramatically between May and September.
Like almost everyone, we believe the long-term story for bonds remains challenging. Below is a chart of interest rates over the last 100+ years from TD Economics. You can see there was a 40 year period of rising rates starting after WWII and we’re now 30 years into a period of falling rates. If rates have bottomed then risk-averse investors may remain frustrated for some time.
This said, we don’t believe 2014 will be as bad as 2013 for the bond market. Much of the negative pressure in the middle of 2013 was caused by uncertainty on what exactly the Fed was going to do with their QE programs. This caused a “whipsaw” effect. There has been greater clarity since September: we now know Janet Yellen will replace Ben Bernanke as Fed Chairwoman; we know what the initial reduction in QE looks like; plus we have gotten over the first shock of the government easing their foot off the gas pedal. The expectation is the Fed will back off a little more of their monthly bond purchases following each of their next several meetings (they have 8 meetings a year).
For our fixed income models, we look to keep duration low, i.e., shorter average maturity and higher average yield, which was a decision we made allowing our models to perform better in 2013. Additionally, for 2014 we look to adopt what we are calling a barbell approach to credit risk where we push a good chunk of the exposure to safer holdings (short government & cash-like) and slide the balance to higher yielding bonds albeit still with relatively short durations. This creates a “barbell” effect given the middle of the credit curve doesn’t attract us much at all.
CURRENCIES
Currency exchange rates are just about the most difficult thing to predict, but we expect the clear trend in the USD-CAD exchange rate (CAD dropped ~7%) to continue through 2014 for all the reasons previously mentioned: Canadian economy more stagnant; Canadian’s high personal debt; US oil independence; foreign investment in US; and so on. We took advantage of a weakening CAD for our Canadian clients in 2013 by investing more in USD bonds and USD based holdings whether direct investments or foreign investments hedged to USD.
We also expect the USD to be strong against other major currencies as well. The Yen has fallen apart the last 15 months and dropped more than 20% in 2013 alone. The Yen should continue its struggles but not at the same pace. The surprise to us through 2013 was the resiliency of the Euro versus the USD. We thought the Euro would have weakened last year, yet despite all of Europe’s economic woes it has climbed nearly 15% in the last 18 months versus the USD. We continue to believe this trend will reverse itself in 2014 given the different economic positions of the two regions – the US government is pulling back on its QE program, while it’s argued the EU may have to provide more support especially if there are any banking issues.
SUMMARY
All this said, markets are tough to predict accurately and the most important thing is to remain nimble and to avoid tunnel vision or data mining. We find it better to try and poke holes in our own beliefs rather than hunt for data to confirm your views. If the market appears to hit a wall with momentum beginning to wane, and some of the fundamental data turns south, then we have to be prepared to get defensive. We want to participate in returns similar to the +20% we’ve seen 33 times in the last 50.
ABOUT TURN8 PARTNERS
Turn8 Partners is a discretionary investment management firm providing comprehensive Wealth Management Advice and
Investment Services to exclusive clientele in Canada and the United States. Combining forward-thinking solutions, based on a professional foundation, we implement and manage customized wealth management strategies to ensure the realization of our client’s goals.
DISCLAIMER
The information above is not directed to any person in any jurisdiction where (by reason of that person's nationality, residence or otherwise) the publication or availability of the information is prohibited. The contents have been prepared to provide you with general information only and do not constitute any investment recommendation. In preparing the information, we have not taken into account your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation and needs. The information contained herein has been obtained from sources that we believe to be reliable, but its accuracy and completeness are not guaranteed. Any examples shown are purely hypothetical and have been included for demonstrational purposes only. Past investment performance is not indicative of future investment performance and the value of investments and the income from them can fall as well as rise and are not guaranteed. You may not get back the amount originally invested. Any reference to returns linked to currencies may increase or decrease as a result of currency fluctuations. Any references to tax treatments depend on the circumstances of the individual client and may be subject to change in the future. Nothing provided should be constituted as an offer or invitation to anyone in any jurisdiction where such offer or invitation is not lawful, or in which the person making such offer or invitation is not qualified to do so, nor has it been prepared in connection with any such offer or invitation. We reserve the right at any time and without notice to change, amend, or cease publication of the information. For further information please contact us.
Copyright © Turn8 Partners
