Stocks advanced powerfully in 2013 driven by an improving US economic outlook and ultra-easy monetary policy by the Federal Reserve. Most notable was the purchase of $85 billion per month of Treasury and mortgage-backed securities, often referred to as quantitative easing or QE for short. On the year, the US stock market, as represented by the Standard and Poor’s Five-hundred stock index, rose 29.6%. It closed at 1848, an all-time high. High quality bonds had a difficult year as investors became more positive on the US and world economies and moved into riskier assets such as stocks, junk bonds, and higher yielding European debt. The yield on the benchmark ten-year Treasury note increased 128 basis points (hundredths of a percentage point) to yield 3.04%. (Yield moves inverse to price.) Gold suffered heavy losses on the improving outlook, as much feared inflation failed to materialize. On the year, gold declined 28.2% to $1,202 per ounce. Crude oil increased 6.5% to $98 per barrel likewise on the improving economy.
For 2014, investor consensus is nearly universal. Essentially, the trends of 2013 described above will continue, although at a more moderate pace. The stock market will move steadily higher on an improving economy, while bond prices will continue to grind lower (yields higher) as the Federal Reserve slows its rate of bond purchases, also referred to as “tapering”. This scenario is plausible, yet not assured.
The biggest risk to the bullish consensus for stocks in 2014 is a more rapid improvement in the unemployment picture than investors and the Federal Reserve anticipate. If the unemployment rate (currently at 7.0%) were to fall by midyear to below the Fed’s 6.5% threshold to consider raising overnight interest rates, investors would begin to worry about the potential for higher short-term interest rates sooner rather than later. This could lead to a disorderly selloff in bonds (higher yields), as opposed to the gradual increase in yields that most strategists and analysts are calling for. A sharp selloff in bonds would likely have a direct, negative impact on stocks. After having advanced as far as it has virtually uninterrupted, the stock market is vulnerable and could suffer a sizeable correction if this scenario were come to pass. Higher US bond yields could also wreak havoc in foreign markets, as well.
Turning to further risks, Europe bears watching. It seems to have stabilized, but European economies are still operating at a depressed, fragile level. A deterioration in European economies would be bad for the global economy and could pressure US stocks, although it would likely be good for US bonds, which would be seen as a safe haven. Chinese local governments are heavily indebted and are a serious threat to continued strong growth in the world’s second largest economy. Weakness in China could spread to other emerging market economies, and US markets would not be unaffected. Finally, there are political and geopolitical risks such as the need to raise the US debt ceiling this spring, instability in the Middle East, and the standoff in the East China Sea between China and Japan. All have the ability to significantly impact US markets.
We find the consensus outlook more likely, but the risks cited above are probably more of a threat than investors realize. We will continue to execute our strategy of investing in high quality income producing securities, such as dividend growing equities and investment grade bonds, reinvesting the income, and compounding returns. For 2014, we see the S&P 500 trading in a range of 1725 to 2025. It ended the year at 1848. We forecast the ten-year Treasury note to trade in a range of 2.50% to 3.75%. It ended 2013 yielding 3.04%.
For the fourth year running, we are pleased to have been named a Five-star Wealth Manager as described in Chicago Magazine. Fewer than 3% of the 11,800 financial services professionals in the Chicago area are chosen. A detailed description of the award can be found on pages FS 1 and FS 2 of the November 2013 issue of Chicago Magazine. More details are available at Fivestarprofessional.com