"We are less optimistic about U.S. equities than we were a year ago, though we still believe they are more attractive than bonds at current prices." - PRIMECAP Management Company, in their October 11, 2013 annual report to shareholders.
2013 was another surprising year for equities. The S&P 500 or large company index was up 32%, the Russell 2000 or small company index was up close to 39% and the MSCI EAFE or foreign stock index was up close to 23%. As you will see on the enclosed Position Performance Report, our equity funds - for the most part - met or exceeded those benchmarks. There were some exceptions: First Eagle US Value, IVA International and First Eagle Overseas trailed their respective benchmarks due to the gold and cash positions they held. All three of these funds will be the first to admit that they will lag in bull markets like 2013. Due to their strong performance in bear markets, or when markets go down by 20% or more, I have continued to hold them as a type of hedge in case the market goes the other way on us.
The fixed income side was less impressive. The Barcap Aggregate Bond Index was down about 2% for the year. Bonds were down during the year due to the Federal Reserve commentary that they would end or taper the long-term bond buying program otherwise known as Quantitative Easing, or QE, when they thought the economy was improving. This spooked bond investors nerves to the point where they sold their bonds and either went into money market or stocks. When bonds are sold in large quantities bond prices go down and interest rates go higher. There was a slight recovery in the second half of the year, but the index did not have enough to break into positive territory by the end of 2013.
I made some changes to the model and, thus, to your existing portfolios in the middle of the year. Essentially you now have 75% in short-term bonds and 25% in intermediate bonds. As mentioned in previous letters, I prefer to take the risk with our stock allocation and not with bonds and cash.
What can we expect from 2014? With 75% of our fixed income in short-term bonds, you would be right to conclude that I am concerned about rising interest rates in the years ahead. After a 32% gain for the S&P 500, one would normally think after having gone through the 2000-2002 and 2008-2009 time periods that the stock market was due for a correction or possibly a bear market. However, I believe stocks can still produce positive results in the years ahead. I base this expectation on the following thoughts:
Liz Ann Sonders, chief investment strategist for Charles Schwab, stated in the February issue of Kiplinger's personal finance magazine that while they saw a pick-up of money flowing into stock funds in 2013, this "new cash has barely made a dent in net outflows of $600 billion since 2008." Let me explain this quote. Since the dawn of time, there has been a tendency for new cash to chase hot investments when valuations and other stock market measurements would tend to give a prudent investor pause. Likewise, during depressed market conditions the opposite holds true. Investors tend to pull money when valuations are the cheapest. What Ms. Sonders is referring to in that quote is that there hasn't been a lot of new cash chasing the stock market even though we have had significant gains since 2008. This means that investors seem to be a bit cooler to stocks at present.
Sonders continues, "As for the stock market being overvalued, Standard & Poor's 500–stock index is trading at a little more than 15 times estimated corporate earnings for 2014. The long-term median is 16.5 times year-ahead earnings." This simply means that she believes the market to be fairly valued but not overvalued, which is a much different scenario than in the late 1990s. With interest rates still near historic lows today, maintaining or growing corporate earnings will be the focus of investors around the world.
There is also a theory that as rates begin their inevitable climb up and as the economy continues to expand, long-time bond investors will jump bonds and move more of the proceeds to equities. We have seen some of this in 2013, but the big question is how much is left? Of course, a natural disaster or a bad geopolitical event could send investors back into the perceived safety of bonds.
With all of that said, I would be tickled with a positive 4 to 5% equity return in 2014. If our overall bond investments can return 1% or more, I would also be pleased. As the year plays out, I will watch earnings expectations for hints as to how the market will perform going forward. In the meantime, I feel as though we have a good mix of funds: Some will perform better in bull markets and some will perform better in bear markets. After all, no one knows what the future holds.