The domestic stock market closed the year with a strong finishing kick. The S&P 500 returned 10.5% in the fourth quarter to push the calendar year return to 32.4%. All other asset classes struggled to keep pace with domestic large-cap stocks; but, most equity asset classes posted solid returns for the quarter as the MSCI All-Country Stock Index returned 7.4%. The losers for the quarter, and the year, were bonds (with the exception of high yield taxable bonds). US Treasury bonds were the hardest hit taxable bond sector—down 0.9% for the quarter and 3.2% for the year. Investment grade municipal bonds returned 0.4% for the quarter, but the calendar year return was a negative 2.9%. The biggest loser for the year was the high yield municipal bond market—down 6.2% due to the uncertain implications of the Detroit bankruptcy.
The government shutdown in October put some downward pressure on stock prices early in the quarter, but after that initial dip it was pretty much straight up for the balance of the quarter. Even the Federal Reserve’s announcement in December that it would begin tapering its bond buying activities didn’t deter stock investors. As noted above, it was a much different experience for bond investors. 2013 was the worst year for investment grade bond investors in two decades; and, it was only the fourth calendar year in the past forty years in which the bond market posted negative returns. Interestingly, this past year was the first time the bond market posted negative returns in an environment in which the Fed wasn’t pursuing a tight monetary policy. The Fed’s balance sheet now stands at $4 trillion—about 5 times larger than it ever was prior to the financial crisis—one has to wonder what happens to bond returns should the Fed actually attempt to shrink that balance sheet to some level of normalcy.
All but the most conservative of our clients’ portfolios experienced strong absolute and relative returns. The growth (equity) sleeve provided the greatest absolute returns for the quarter. The non-traditional holdings (senior bank loans, preferred stocks, BDCs and distressed credit) in the income sleeve provided the most significant relative outperformance. As a group those holdings provided a positive 3% return in a period in which traditional fixed income holdings had a negative return.
Despite the run-up in equity prices in 2013, our outlook remains optimistic. Stock prices follow corporate earnings and we believe the corporate earnings environment remains positive. Recent economic data has all surprised to the upside; the bipartisan budget agreement removes an uncertainty; and, the Fed remains committed to anchoring short-term interest rates near zero percent for the next few years. We are approaching the fifth anniversary of this bull market—it is typically at this stage we expect to see price-to-earnings multiple expansion. P/E multiples for the domestic stock market are about 5% below their historic average—it is not uncommon, in the late stages of a bull market, for those multiples to expand well past their historic averages. We believe strong corporate earnings and price-to-earnings multiple expansion could generate another year of positive returns in the domestic equity market.
We remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.