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VOL. 129 | NO. 45 | Thursday, March 6, 2014

David Waddell

Looking Backward and Forward

By David S. Waddell

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The Look Back This time last year we predicted that 2013 would revive investor animal spirits. In fact, investors were downright euphoric last year, absolutely gorging themselves on stocks, buying at a record pace.

Given our confidence in surging investor spirits, we expected the stock market to reach new highs, which it did. While the U.S. market climbed 32 percent, the ex-U.S. markets gained only 16 percent continuing their dramatic underperformance to our surprise.

We expected surging spirits to lead to surging interest rates and, in fact, the yield on the 10-year Treasury bond rose an historic 72 percent. As a consequence we expected interest rate sensitive bonds would fall, which they did.

We predicted that the Euro would actually appreciate against the dollar, which it did. Finally, we feared that this surge in animal spirits might lead to a surge in investor confidence, which could stimulate economic confidence, leading the Fed to prematurely extinguish quantitative easing.

While we did see a surge in stock market spirits, we did not see a surge in economic spirits, and the Fed stayed sidelined.

A Look Forward The S&P 500 climbed 32 percent last year. Dividends and buybacks contributed 2.8 percent, while growth in earnings contributed 11.2 percent. The rest of the return came from an 18 percent expansion in the P/E multiple.

Using this framework to project 2014 returns we will get our 2 percent dividend yield and earnings should grow 8 percent or so. However, the determinant for stock market returns in 2014 will be the change in valuations. With the P/E already above its historic average and the Fed backpedaling on quantitative easing, valuations could actually decline.

A 5 percent decline in valuations would compress returns to 5 percent. So our return outlook for the U.S. market is rather meager.

However, the valuation condition of the U.S. does not match the valuation condition abroad. While the U.S. markets today appear overvalued, the international markets are equally undervalued. When you add it all together, the valuations and return opportunities worldwide still remain attractive.

Our Outlook for 2014 Given the crosswinds of more global growth, continued global deleveraging, high degrees of investor sentiment paired with lofty domestic valuation, a poor economic policy array from Washington and less Fed, we expect 2014 to be a pretty choppy year. We believe that in 2014, you should “Taper Your Enthusiasm.”

In the U.S. stock market, we expect the fundamentals to grow but valuations to shrink. We expect large company stocks to outperform small company stocks. We expect active money managers to outperform indexers. We expect higher international than domestic returns. We expect U.S. interest rates will be little changed and therefore expect bond returns will be little changed. We expect the dollar to move higher as quantitative easing winds down. Lastly, we see the primary market threat as overconfidence as the down force from global deleveraging continually suppresses growth.

Economic overconfidence could lead to poor policy decisions out of the Fed and provide cover for continued poor policy decisions out of Washington.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.

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