January, 2014
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

The start of a new year always brings with it the bifurcated process of looking backward through the year just completed as well as looking forward to what might be coming in the year ahead. In 2013, the world experienced:

Newsmakers:

Births & Deaths:

Controversial Government Programs:

Tragedies:

And a stock market that did this:

The markets had to start the year dealing with the uncertainty surrounding the “Fiscal Cliff” and then navigate such events as the sequestration, a debt ceiling debate, a change in the direction of interest rates, a government shutdown, and the Federal Reserve’s decision to taper it’s Treasury Bond purchases. Through all of this, stocks rode the improving economy and managed to climb to all time highs, though much doubt existed along the way.

Index 4nd Qtr
2013
Return
1 Year Return 3 Year
Annualized Return
5 Year
Annualized Return
S&P 500 10.5% 32.4% 16.2% 17.9%
Dow Jones Industrial Average 10.2% 29.7% 15.7% 16.7%
Nasdaq Composite 11.1% 40.1% 17.7% 22.9%
Russell 2000 – Smaller Companies 8.7% 38.8% 15.7% 20.1%
MSCI EAFE – International 5.7% 22.8% 8.2% 12.4%
Barclays US Aggregate Bond -0.1% -2% 3.26% 4.4%

2014

So that’s looking backward, what about looking forward? The human tendency is to infer that the way things have happened in the recent past are the way that things are going to continue to go in the future. This is a little bit like driving while only looking at your rear view mirror; a practice that, unless you have the skills of Mater from the Pixar movie “Cars,” we do not recommend. It is also not a prudent way to approach your investments. The theory that the market will continue to go up, because it has been going up is obviously flawed, but so is the one that says, because the market is up, it has to go down soon. Financial blogger Josh Brown wrote in a recent article, “the next time you hear someone say we’re overdue for a correction, ask them for a copy of the schedule. Unfortunately, markets are biological rather than mechanical in nature and, as such, precision in timing is nowhere to be found.” History shows that market trends can continue longer than anticipated and also change direction at a time and with a magnitude that catches many by surprise.

You can always find analysts on both sides of the bull/bear debate, even when it comes to determining if the market’s valuations are expensive or not. There are folks who cite the Cyclical PE (Price to Earnings) ratio and state that the market is rich (25.4 vs. the historical average of 19.1), while those using the Forward PE claim that the market still has plenty of room to run (15.4 vs. 15-yr average of 16.2). The reality would seem to lie somewhere in between with the overall numbers saying that while the valuations are on the high side, meaning they are slightly overvalued, they are not in what we would consider bubble territory. We expect there to be a continued tug of war – on one side there is improved economic growth and on the other side is the impact of reducing government stimulus. The strength or weakness of either side will determine how investments will perform in 2014. If the growth we are seeing becomes greater than expected and happens on a global scale, then we could see continued new highs being set. However, if the unintended consequences resulting from an unprecedented monetary expansion prove the doomsayers right, then the correction could be steep. We will continue to invest our client’s funds with this tension in mind.

Interest Rates

One of the things we saw this year was the likely low point of interest rates. Rates were near all time lows this spring when the Fed began talking in earnest about the possibility of instituting its tapering program. This caused rates to spike and they remain significantly higher than the lows of the spring. We would indeed expect that the Federal Reserve would completely phase out their bond-buying program throughout 2014, though comments from Fed officials continue to emphasize that they will likely keep the Fed Funds rate at near zero for a considerable time even after the bond purchases are completed.

An interesting study looked at how the stock market performed in a rising interest rate environment. The results showed that when rates (measured by the 10 year Treasury yield) were low and rising, this usually led to a rising stock market. When rates were high and rising, the market has dropped. The differentiation point between high and low, while not precise, was in the neighborhood of 5%.

This rising interest rate environment has caused us to be more selective and more diverse in our fixed income investments. We have reduced the amount of traditional intermediate term bonds and have increased the amount of low duration, less interest rate sensitive holdings. In addition we have added to our international bonds. In 1989, the United States issued 62% of the worlds bonds, now that amount is down to 42%. Both the developed and emerging market portions of the international bond market are creating more opportunities for investment.

Some other economic data that we are watching:

  • The most recent Real GDP is 2% year over year growth
  • Two of the most important cyclical sectors: Light Vehicle Sales and Housing Starts both continue to climb
  • Inflation remains low at 1.2% thanks largely to lower energy costs and no thanks to medical and housing costs
  • Average Hourly Earnings have grown 2.2% since last year
  • The unemployment rate has fallen to 6.7%

Speaking of unemployment, we will close this letter with a chart that might be worth sharing with someone you know who is a teenager or younger. It shows the unemployment rate and the average annual earnings broken down by education level. This makes a pretty compelling argument for the financial benefit of a college education.

Included with this quarter’s letter, our clients will find a “Suitability Questionnaire.” Please complete this form and return to us at your convenience to make sure that we are up to date with any adjustments that may have taken place in the past year with respect to your investment goals and/or appetite for risk. If you have any questions about it, feel free to give us a call.

In light of the new year, our website has a new look and we’ve added some new features including informational videos, a blog, and more...feel free to take a look and provide your input. We look forward to hearing from you! Here’s to a great 2014!

Sincerely,
The Castle Investment Advisors®, LLC Investment Team

                    
 
Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.