Any investor that owned a reasonable percentage of U.S. stocks in their portfolio last year should be feeling pretty good. Including dividends, the S&P 500 soared 32.4% in 2013 - its best performance since 1997 and the 11th best year since 1926. Despite higher taxes, fiscal austerity, a near-war with Syria, and a 16-day government shutdown, the ride was still uncommonly smooth. The stock market suffered only one decline of more than 5% during the year, the fewest since 1995.
For bond investors, it was a year to forget. The Fed’s not too- subtle signaling of its intention to end Quantitative Easing (QE) led to a bond market rout over the summer. Interest rates have since stabilized, but most investment grade bond portfolios had their income gains largely wiped out by declines in principal value.
Stocks have wobbled a bit out of the gate in 2014, and the market bears are in the news talking about lofty valuations, extreme bullishness, market bubbles, and the need for a “healthy correction.” Despite the spotty record of most market forecasters (see last month’s Market Perspectives column entitled “An Inconvenient Truth”), it is natural to be concerned about relinquishing one’s hard fought gains.
At City National Rochdale, we believe that stock prices are driven by earnings growth over the long term, and earnings growth at an aggregate level is driven by economic growth. So attempting to divine the direction of stock prices must begin with a forecast of future economic activity. Our U.S. Economic Monitor (please see Figure 1 on page 2) scores 15 different components of economic activity (e.g., labor market activity, consumer spending, geopolitical risks, and inflation) in order to estimate the future strength of the U.S. economy. From there, we develop an estimate of forward earnings growth by incorporating elements such as profit margins, international growth, and share buybacks. By estimating what investors are willing to pay for this future growth (the price/earnings multiple), we can arrive at an estimate of the return for the stock market for the coming year.
Complicating these forecasts are three important variables: uncertainty, expectations, and human behavior. Predicting anything as complex as the global economy is exceptionally difficult. One could be dead right about U.S. economic growth, but get the market forecast terribly wrong because investors had already expected a certain outcome and priced stocks accordingly. Finally, the tendency for humans to overreact to short term events creates more anxiety in the markets than is justified by economic fundamentals. Getting all of this right is no easy matter.
So is it time to sell your winners (stocks) and buy your losers (bonds)? We think not, at least not yet. Our Economic Monitor continues to point to strengthening activity in the U.S. and stabilization in the rest of the world. While equities are indeed approaching the top end of their fair value range, this should not be a limiting factor to higher stock prices as long as the economy is experiencing non-inflationary growth and the rest of the world is healing. We admit to having no crystal ball, but until economic conditions change, the path of least resistance for stock prices appears to be up.
Figure 1: City National Rochdale U.S. Economic Monitor
Source: City National Rochdale Proprietary Stock Market Multi-Factor Model, January 1, 2014.
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This article is for information and education purposes only and does not constitute a personal recommendation or take into account the particular investment objectives, financial situations or needs of individual clients. Any opinions, projections, forecasts and forward-looking statements presented herein are valid as of the date of this document and are subject to change. Clients should evaluate the merits and risks associated with relying on any information provided.