After the huge market recovery we saw in 2013, it seems
unlikely that we will see a repeat performance in 2014. What seems more probable is that we will see
corrections and rallies around current market levels and, given the expected
continued recovery of the U.S. economy from six years of recessionary and
deflationary conditions, at least some positive overall movement in the
markets. In other words, the equity
markets will probably be up in 2014, in response to improving economic
conditions and corporate profits, but not nearly as much as they were last
year. By the same token, we would expect
the bond markets to be down, as long-term interest rates begin to rise, in
response to the Federal Reserve’s gradual pull-back of its historical
quantitative easing posture.
The Federal Reserve had a very big impact on both the U.S.
economy and the equity and bond markets in 2013. The magnitude of the Fed’s actions over the
past five years is quite remarkable. When
the financial crisis hit in 2008, the Fed’s balance sheet stood at a fairly
normal level of about $800 billion. It
is now five times as large at nearly $4 trillion. This is the result of successive rounds of
“quantitative easing” (QE), in which the Fed has bought U.S. Treasury bonds and
mortgage backed securities, which has had the effect of both monetizing the
federal deficit and flooding the country with newly created dollars . In its latest QE round, which began in
September 2012, the Fed has bought $85 billion in bonds per month, an
annualized rate of over $1 trillion.
Just now they have started to “taper” this program with the potential of
ending it before year-end. Where did all
this money go? While it’s impossible to
say exactly, some of it went into the housing market to fund mortgages, but a very
large portion of it has certainly found its way into the equity markets, thus
driving up stocks.
It is remarkable that this vast creation of money has not
caused inflation (i.e. too much money chasing too few goods). This would indicate that, without the Fed’s ultra-liberal
posturing, the economy might well have fallen into a deflationary spiral in the
last couple of years, which would have had a very negative effect on the world
economy and equity markets.
The trick, then, will be for the Fed to begin pulling back
on quantitative easing in 2014 without negatively affecting the U.S. economy
and equity markets. There will be a lot
of anticipation, which is likely to result in some degree of market correction,
as we go through the year.
It is our intention to stay invested throughout the coming
months and look for opportunities to deploy additional capital. Here is what we said a year ago in “The Case
for Stocks in 2013”, which bears repeating as we begin this new year:
“When all is said and done, the shares of strong,
undervalued companies are perennially the best investments. And that’s
exactly what we have said and done for years. We look for companies that
create economic value by perennially producing returns on invested capital that
exceed their costs of capital and look to buy them when they are
undervalued. Buying and holding stocks has been difficult, at times, in
the last 10-12 years but, during that long and sometimes unsettled period, it
has been, and continues to be, the right way to invest.”
The key word above is
“undervalued”. While we have all enjoyed
the run-up in equity prices of the last year, it is hard to find good companies, i.e., those without “issues”,
that are not at least fully valued in this market. It’s been quite a few years since we have
seen this kind of situation, but history teaches that corrections are always in
the wings in this scenario. So the
question is not if a correction will come, it is what will cause it and
when. Given the huge reliance of the
economy and equity markets on the Fed’s QE strategy, as important as it has
been, it seems likely that the Fed’s exit strategy and how it is executed by
the new Fed chair, Janet Yellen, could be the likely source of concerns in the
market over the next 12 months. The
other imponderable, of course is the geopolitical situation, terrorism etc.,
which is always on our radar screen.
So, we will watch, wait and
analyze. We have quite a few names we
would like to own, in addition to our current portfolio so, when the time comes
to deploy additional capital, we are ready.
Happy New Year!
Jack and Peter Falker
January 10, 2014
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