We ended the year on a high note. Equity markets surged in the 4th quarter ending the year at record highs. The equity market charged ahead +10.51% in the last three months of the year leaving year end gains at +32.39% as measured by the S&P 500. Consumer discretionary and healthcare sectors were the top performing areas while energy, utilities and telecoms lagged by a wide margin. The U.S. was once again one of the top performing markets around the globe.
European equity markets rebounded with most countries up mid-teens even though the continent continues to struggle with slow economic growth. Japan was the bright spot overseas rising almost +60% to end the year at 16,291.31. Although Japan equities were strong in 2013, the Nikkei is still a far cry from the high of 38,915 set back in 1989. Developed market equities were up +23.57% as measured by the MSCI Index thanks mostly to the Japanese market. Emerging markets were once again a problem area with the Emerging Market Index retreating -2.41% for the year. Commodities were another weak area with the CRB index retreating -5.27%. Gold and silver suffered their biggest declines in over three decades, down -29% and -36%, respectively.
The market gains throughout the year exceeded that of corporate earnings growth which has caused equity valuations to expand. The price/earnings ratio of the S&P 500 started the year around 14.5x and now stands at 17.3x which is closer to historic norms given the interest rate environment. While we do not believe equities are considerably overvalued, we will be monitoring corporate earnings growth to asses if these market gains are sustainable. Absent significant future earnings growth, it is unlikely the equity markets will repeat another year like 2013. However if the economy continues to gain strength, more normal gains should be likely.
Interest rates also went out on a high note in 2013 with the 10-yr Treasury (10 Yr) sitting at 3.03%, which is a level not seen since early July, 2011. The 10 Yr began the fourth quarter at 2.62%, was bumpy to a low of 2.50% in late October, and was pretty much straight up (prices down) through year-end. For all of 2013 it was a similar story, but with a wider range and more volatility. The 10 Yr began the year at around 1.78%, fell to the yearly low of 1.63% in early May, peaking first at slightly north of 3.00% in early September, back to the October low, and rising steadily through year-end.
For the fourth quarter, the Barclays Intermediate Government/Credit Index was essentially flat at negative -.02%, bringing the YTD return to negative -.86% on the back of continued volatility and a low-to-high rate move of 140 basis points (1.4%) from the May low of 1.63% to 3.03% at year-end: nearly double. Within the major sectors, Intermediate Government/Agencies were among the worst performing at negative -1.25% for the year. Intermediate Corporates returned +.08% for the year, with a wide dispersion between Industrials (negative -.70%) and Financials (+1.36%).
In December the Fed finally signaled the economy has improved enough to ease off the gas just a smidge. The long anticipated tapering is set to take place this month with the Fed purchasing only $75 billion of Treasuries and mortgage-backed securities instead of $85 billion. Even though the dreaded taper has begun, Bernanke also indicated rates will remain low for the foreseeable future as the economic recovery remains “far from complete.” Rather than throwing a tantrum like in the spring when tapering was hinted by the Fed, equity investors bid prices up to a new record high for the Dow Jones Industrial average the day of the announcement. The bond market also took the news in stride with the 10 yr rising about 19 basis points from the announcement through year-end.
What does this mean for the markets going forward? The economy is expected to continue to improve, albeit sluggishly. As the economy improves, interest rates should continue their march upward toward normalcy. Even though this may cause some jitters, it will be healthy for the markets and our country in the long run. As the economy heals and the Fed reduces its intervention in the markets, asset prices will adjust accordingly, corporations will continue to produce products and invest for the future and we will continue to search for solid investments with an acceptable risk/return profile. And as always, we are working to identify companies with valuations we feel are more attractive than the broad market.