’Tis the season for many in the financial community, as well as pundits in the media, to make bold predictions for the year ahead. The vast majority of you already know our take on the futility of short-term market and interest rate forecasts (as Warren Buffett once proclaimed, “The only value of stock forecasters is to make fortune-tellers look good”). Nonetheless, we thought we’d share our observations along with some general words of advice.
First, in the global stock markets, 2013 was a milestone year of sorts, marking the fifth anniversary of the collapse of Lehman Brothers and the onset of the financial crisis. While the so-called advanced economies continue their slow and bumpy recovery, the general rebound in share prices, including the robust returns we experienced here in the U.S. in 2013, has been nothing short of remarkable. Indeed, the S&P 500, which is still just a proxy for one segment of the equity markets, namely large-capitalization U.S. stocks, has compounded at nearly a 17% annualized rate over the past five years, nearly double its long-term historical average (some of which, of course, made up for ground lost during the financial crisis).
The magnitude of this run, fueled at least in part by the Federal Reserve’s monetary juice, has led to a fair amount of conjecture as to whether we’re in the midst of another stock market bubble. Unfortunately, bubbles are easier to identify after the fact. As a recent Economist magazine article on this very subject posited, “If assets are obviously overpriced, why don’t smart investors take advantage and sell?”1 (Taking this one step further, would those who buy shares from these smart investors all necessarily be dumb and uninformed?) While many valuation metrics, including one commonly cited and associated with Robert Shiller, who shared the Nobel Prize for economics in 2013, are certainly above their longer-term historical averages, they are still below the levels reached during the dot.com heyday. As the Economist elaborated, “There is nothing like the same excitement about shares that was seen in the late 1990s; net flows into (stock) mutual funds only just turned positive this year. Another measure of public indifference is that CNBC, a television station that tracks the financial markets, suffered its lowest ratings since 2005 in the third quarter.”
Regardless, we do think it’s prudent to keep one’s expectations of future returns modest, particularly after such a strong run, and to remember that stocks can be volatile in any environment. As we know all too well, the “price tag” of earning the premium, inflation-beating returns provided by stocks, in aggregate, relative to bonds, has been to withstand some occasional not-insignificant downturns—and associated stomach churning—along the way. For perspective, the average intra-year decline for large-cap U.S. stocks since 1946 has been approximately 14%. Furthermore, there’s been a 15% to 19% drop, on average, every one year in three. Yet we haven’t experienced an intra-year decline of that magnitude since 2011. In fact, during 2013 the largest decline was just 6%.2
Please note that this is not meant to imply any type of forecast on our part. Indeed, there have been long stretches, such as during the 1990s, when we went without even a 10% correction. Our main advice is simply not to be surprised when the inevitable interim downturns occur. Furthermore, while one may be tempted to make hasty portfolio shifts in anticipation of a stock market correction, don’t forget that doing so entails a second challenge—and risk—of correctly timing one’s reentry into the market. As famed investor and author Peter Lynch once cautioned, “Far more money has been lost by investors preparing for corrections and trying to anticipate corrections than has been lost in the corrections themselves.” The bottom line is that we believe it’s ultimately more productive to remain focused on the longer-term, upward trajectory of the market, which we have every reason to believe will persist (capitalism demands nothing less, after all), but to accept that it’s a jagged slope…as much as we’d wish otherwise.
Now let’s turn our attention to bonds, for which there is also broad concern—both in the media and elsewhere—as to whether we are in a “bubble.” This trepidation is understandable, given that yields are still at historically low levels (although higher than this time last year), and bonds do have a chance of posting negative returns over the short term, stemming from falling prices if interest rates spike. But perspective is in order here too: Bonds are not stocks and their returns historically have not behaved as such. Since 1926, the worst 12-month return for bonds, as reflected by broad gauges of the total U.S. bond market, has been –13.9%. While painful, this loss pales in comparison to the worst 12-month return for stocks, –67.6%.3 Moreover, a widely accepted, broadly used definition of a bear market for stocks is a decline of at least 20% from peak to trough, while some in the industry would define a bear market for bonds as simply a period of negative returns. We also take issue with the term “bubble” as it applies to bonds. Much of the current concern pertains to interim price declines from rising interest rates, before bonds mature at their par value (i.e., the original issue amount)—particularly high-quality bonds and CDs, which we typically purchase. This is a far cry from a general stock market decline, or a true bubble like the dot.com craze, when numerous companies, and their respective stock prices, completely evaporated.
With that said, no one enjoys seeing negative returns, particularly for their bond holdings. The concern regarding rising rates does tend to be more acute, though, for bond funds, as opposed to individual bonds, given the former’s lack of maturity dates and return of principal (with bond funds, your ultimate return is known only once your fund shares are sold). However, it’s important to bear in mind that when interest rates rise, so do bond yields. Therefore, while a fund may incur an initial price decline, this will be offset over time as bonds mature in the fund and are reinvested at higher yields. All else being equal, this should result in a higher total return for longer-term, buy-and-hold investors who stay the course. For those of you interested in more detail about what to expect in the face of higher interest rates, and how we manage your fixed-income holdings, we refer you to our October 2012 client newsletter, entitled Your Bonds: When Rates (Eventually) Rise (click on link).
In a nutshell, just as we caution against market timing with stocks, we advise you to refrain from making knee-jerk reactions to your portfolios based on interest rate bets. While it certainly seems that interest rates can only head in one direction from here, there’s no telling when this move will occur, or in what magnitude. After all, many have been forecasting rising rates for more than a decade. Rather than trying to predict the unpredictable, for either stocks or bonds, we continue to believe you’re much better served by focusing on the elements you can control—striking the appropriate risk/reward balance (per your Investment Policy Statement), maintaining broad, global diversification, and minimizing unnecessary costs and taxes.
Now on to the general financial planning front, with some items to note for next year:
- The maximum federal tax rate on qualified dividends and long-term capital gains remains 20%, but only for taxpayers who are in the 39.6% marginal income tax bracket. Investors below those thresholds will continue to pay a maximum 15% rate on qualified dividends and long-term capital gains. However, these figures do not include the 3.8% Medicare tax on so-called unearned income for singles earning more than $200,000 and couples earning in excess of $250,000, as mandated under the Affordable Care Act.
- Maximum IRA contributions remain $5,500 for those younger than 50 and $6,500 for those aged 50 and up.
- Eligibility income ceilings for Roth IRA contributions increase, with contributions phasing out at adjusted gross income thresholds of $181,000 to $191,000 for couples and $114,000 to $129,000 for singles.
- The annual contribution limit for 401(k), 403(b), and 457 plans remains $17,500 for those younger than 50 and $23,000 for those aged 50 and up.
- The limit on defined-contribution plans (Keogh profit sharing and SEP-IRA) increases to $52,000.
- The estate, lifetime gift, and generation-skipping tax exclusions, which are now uniform and indexed annually to inflation, increase from $5.25 million to $5.34 million per person. The top tax rate remains 40%.
- The annual gift tax exemption remains $14,000.
Finally, we want to extend another welcome to our new clients who have joined us over the past year, and to thank those of you who have referred your family, friends, and colleagues. We’re fortunate that most of our growth comes from our preferred route of referrals, reflecting and affirming the positive experiences of our existing clients. On that note, we appreciate your continuing to keep ELM Advisors in mind should you know of anyone who may benefit from our services.
Thank you for entrusting us with the mission and privilege of helping you secure your financial future. We wish you and your loved ones a happy and healthy 2014.
1. “Asset Prices: Not Fully Inflated,” The Economist, December 7, 2013.
2. Sources: JP Morgan Asset Management and American Funds.
3. Source: Vanguard.