Do You Feel Lucky?
Well, 2013 is in the books and it was a stellar year for anyone who had the moxy to ignore all the rules we’ve been taught about investing. Diversification? Didn’t need it last year. All you had to do was buy US stocks, the more speculative the better, and let it ride. Bonds to reduce risk? Nope, that didn’t work either. Bonds detracted from performance unless you owned junk and like the stock market, the junkier the better. International diversification? Who needs it? Emerging market stocks were down on the year and foreign developed markets lagged the US badly. If you have a contrarian streak, as all good investors do, you weren’t rewarded for buying what was cheap and out of favor last year. Momentum was the only thing that mattered and the more overvalued and the bigger the short interest the better you did. Last year was a year for breaking all the rules of investing and rewards went to those who either didn’t know them or didn’t care.
Stocks rose last year despite a weak economic environment and weak earnings growth. Earnings for the S&P 500 will probably clock in with something like a 7% gain for the year while revenue will be up an even smaller amount. Earnings per share were boosted by an astounding $450 billion in stock buybacks which sounds great until you find out that companies issued over $1 trillion worth of bonds last year to pay for them. While everyone was concentrating on the Fed’s quantitative easing, corporate America went on a borrowing binge fueled by low interest rates that the Fed now assures us will be around for years. QE may not matter but interest rates most certainly do and if you’re still buying this market you better hope the Fed is right – and for the right reasons. If rates stay low because inflation stays low – but not too low – then maybe the re-leveraging of corporate balance sheets isn’t over. If, on the other hand, interest rates are low or lower because the economic acceleration everyone agrees is on the horizon – again – doesn’t happen, well then stock buybacks might not look like a good use of corporate cash. Or God forbid, if interest rates rise significantly and the Fed discovers they have a lot less control than they and everyone else believes, well then stocks may not look nearly as attractive as they do in the rear view mirror.
We started last year with a stock market that was valued for poor future results and we start this year with a stock market that is valued for even poorer future results. I won’t get too deeply into the Shiller P/E debate but it does seem that the bulls are working very, very hard to find reasons to stay that way. One of the most widely touted takedowns of Professor Shiller’s work was riddled with errors and still only managed to conclude that the stock market was 25% overvalued rather than 50%. The simple fact is that there are numerous ways to conclude that US stocks are richly priced, a few that argue for average valuations (none of which have any predictive value) and none to my knowledge that scream Buy! That doesn’t mean there aren’t some stocks trading at cheap prices – there always are – but with indexing now a genuine fad itself, it is the market valuation that matters for most investors.
We started last year with Wall Street analysts looking for double digit gains in corporate earnings and we ended with the highest proportion of negative earnings warnings in history. We start this year with analysts still looking for double digit gains in corporate earnings based on an improved outlook for the US economy – just as they did last year. The US economic stats have improved recently, just as they did this time last year, but the improvement is primarily due to rising inventories – just as it was last year. We don’t know yet how the Christmas selling season came out but last year companies spent the first two quarters adjusting inventories to reality. It might be different this year – UPS’s problems would seem to be a positive sign – but with little improvement in incomes count me as skeptical.
Despite the recent optimism about US growth, I don’t see much that has changed since this time last year. Employment is far from satisfactory and grew last year at a rate barely enough to keep up with population growth. The unemployment rate fell but that was primarily due to a lower participation rate. Investment is still lagging as companies spend their cash on buybacks and other financial engineering. House prices are rising but new home construction is still at levels that are awful by historical comparison and with population growth at Great Depression rates doesn’t look to improve dramatically any time soon. Household incomes are still falling and while consumer credit is expanding to fill the void, one can’t help but wonder how this is any different than what prevailed prior to the Great Economic Crisis of 2008.
There are bright spots and I don’t want to be too negative but the fact is that we haven’t yet done anything from a policy standpoint to address the structural problems with our economy. If anything we’ve added to our problems by attempting to paper over them with monetary policy. Fed policy has enabled a dysfunctional Congress and pumped up asset prices but done nothing for the broader economy unless you happen to be a part of the financial elite that directly benefits from the Fed buying your inventory. We still have a corporate tax policy that is uncompetitive internationally even though everyone agrees it needs reform. Regulatory policy, which needs nothing so much as a little simplicity, has moved in the opposite direction. Taxes are still rising with the Obamacare levies starting this year and you can bet that’s one part of the law that won’t get delayed.
So, what to do? I know what you’re thinking. You’re thinking with everything looking so much like it did last year, shouldn’t I just keep doing what worked last year? That’s what Wall Street is telling you. Ignore the rules of investing and just follow the script that worked last year. Don’t diversify out of US stocks. Don’t buy bonds, they just drag down your returns. Don’t touch gold or other commodities – the dollar is going higher just as sure as interest rates. But being that the stock market is overvalued by either 25% or 50% depending on how you interpret the data, you’ve gotta ask yourself a question: Do you feel lucky? Well, do ya?
If you do, then by all means, keep doing what has worked but I would just point out that luck is a fickle thing and doesn’t really amount to an investment strategy. If you don’t feel or want to depend on luck, you might want to consider doing what has worked for much longer than one year. The rules of investing are rules for a reason – they work over the long term and help you avoid the mistakes that most investors make. Diversification may be something you can ignore in any given year but putting all your eggs in one basket is not generally considered a recipe for long term success. Buying the things that are out of favor may not work in the short term but it is the only way to get a bargain and fulfill the buy part of the adage to buy low and sell high. 2013 was a year to ignore the rules. 2014 may be the year when everyone is reminded of them.
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