In this essay, as I do every year, I am going to review some of the most important strategic developments of 2013, and I will specifically review how well I did in foreseeing these major trends and formulating investments that would outperform the principal benchmarks such as the S&P 500 (SPY) and the Dow Jones Industrial Average (DIA).
2013: A Year of Developed Market Healing; Emerging Markets Reeling
2013 was a year of healing in developed markets. First, after a long and frightening period of contraction in 2011 and 2012 Europe's economies began to stabilize and the risk of an even greater crisis began to recede. Second, the US economy gradually accelerated, employment indicators improved, household balance sheets were strengthened and the US fiscal deficit was reduced very substantially. Finally, the Japanese economy, still reeling from a devastating earthquake and nuclear disaster, began to show signs of life in connection with an aggressive new set of policies implemented by Prime Minister Shinzo Abe and Central Bank Chief Haruhiko Kuroda.
From a financial markets perspective, the most important consequence of this process of healing in the developed world was strong equity price rallies in developed stock markets combined with declining bond prices and sharply rising bond yields.
In emerging markets, the aforementioned trends in developing markets proved to bring about challenges. Restored confidence in the developed world combined with rising interest rates led to "hot money" capital outflows, devaluation of currencies, surging interest rates (EMB), falling stock markets (EEM) and lower growth in nations such as Brazil and India with large current account deficits. East Asia, which enjoys large current account surpluses, nonetheless experienced considerable uncertainty and muted growth in part as a result of the perceived difficulties related to China's attempted transition from an export-driven and construction-led economic model to a more balanced system based on a greater share of internal consumption.
Commodity prices remained tame and/or fell due to decelerating emerging markets demand as well as disinflation in the developed world. Gold prices and the price of gold-oriented ETFs such as SPDR Gold Shares (GLD) collapsed as the allure of the yellow metal as a safe haven waned and as inflation actually decelerated in the US.
In terms of policy, 2013 marked the beginning of the end of aggressive US QE policy. US politicians also managed to reach a fiscal agreement that set aside any short-term risk of default by the issuer of the world's reserve currency.
How Did I Do In 2013?
In the following section, I will review my published 2013 Outlook entitled "Stock Bulls May Have Room To Run, Bond Vigilantes Lurk," as well as my various writings on portfolio strategy throughout the year.
1. US GDP growth to accelerate: Correct. Although I listed various headwinds such as an increase in the payroll tax and overall fiscal tightening due to the sequester, in my 2013 Outlook I predicted that by the end of 2013 the US was "poised to accelerate GDP growth to the 3.0% level and beyond." This was a counter-consensus call at the time as US growth had actually decelerated significantly during the second half of 2012. As I predicted, US GDP growth accelerated throughout 2013 from a 1.1% rate in the first quarter to a 2.5% pace in the second quarter and to a rate of 4.1% in the third quarter of 2013. The US economy seems poised to grow somewhere near the 3.0% level in the fourth quarter once again. Therefore, my optimism regarding US growth relative to the cautious consensus at the time proved prescient.
2. Sell bonds aggressively: Correct. "Bond returns in 2013 will probably be bad, and could be very bad. Yields and spreads are extremely low at a time when the economic cycle and inflation dynamic may be set to turn. A short TLT and/or JNK position can be considered." My call to sell bonds was strongly reiterated in my article, "No Taper is a Gift: Sell All Long-Term Bonds Now." This prediction could hardly have been proven more correct.
3. Overweight equities. Correct. I argued that valuations were neutral, growth fundamentals were supportive, technical factors were positive, while sentiment indicators were mixed. All of these factors led me to suggest a "cautiously opportunistic approach" and an "overweight equity allocation." Having said that, I acknowledge that I did not necessarily envision equity returns of 30%-plus at the beginning of 2014. I also believed that some sort of correction during 2013 was likely as the Fed switched policy gears. However, it is also true that I became increasingly bullish throughout the year due to my thesis regarding the potential emergence of a bubble in the US equity market. This theme has subsequently been picked up on by a large number of analysts and became a hot topic in 2013.
4. Sector/style allocation calls. Excellent - 6 out of 7. I specifically suggested that "the outperforming sectors could be small-caps (IWM), growth stocks (VUG) or (VBK), financials (IYF) and emerging markets (EEM)." The first five picks handily outperformed the S&P during 2013 while EEM was clearly a laggard. Furthermore, as outlined below, my call that dividend stocks would underperform was highly contrarian and turned out to be very prescient. With respect to emerging markets, my constructive stance actually ended in May with the first rumblings of tapering. With respect to commodity-oriented stocks, the oil service sector (IEZ) was my favored sector and it clearly outperformed the commodity sector as a whole, (though it only performed in line with the S&P 500). So I will call that one a tie. However, I clearly signaled gold as a poor performer. Indeed, in April of 2013, with gold still about 20% above current levels, I pounded the table very loudly for investors to liquidate all gold-oriented investments as "Gold Is Entering Its Liquidation Phase." Overall, one could say that my overall record on these picks was 6 - 1 - 1. The total alpha generated in these allocation calls was extremely large - particularly vis a vis my allocation to small caps, growth stocks and my extremely bearish calls on bonds and gold.
5. Dividend stocks will underperform: Correct. In my 2013 outlook piece I said that dividend-oriented stocks should lag in terms of relative performance. And in June I wrote an article explaining why such stocks represented a lose-lose proposition from a relative total-return point of view. After a very strong start, dividend stocks did indeed underperform on a total return basis in 2013. The Dividend Aristocrats underperformed, utilities lagged, the S&P, MLPs (Alerian Index) underperformed, while REITs and mREITs got absolutely clobbered. In fact, S&P 500 no-dividend stocks outperformed dividend-yielding stocks by about 7%, while the outperformance of no-dividend stocks on the broader indices such as the Russell 3000 or Wilshire 5000 was even greater.
6. Consumer price inflation may accelerate: Wrong. In my 2013 outlook piece, I suggested that an acceleration of global growth might cause an uptick in core inflation, led mainly by commodity-driven and imported inflation. I expanded upon this theme a few weeks later explaining in detail how this might occur. However, contrary to my expectations, consumer price inflation actually decelerated. However, as 2013 wore on, I modified my thesis regarding inflation to focus more closely on asset price inflation. This shift in emphasis has proven to be prescient.
7. Asset price inflation: Correct. Starting in May of 2013 I have been warning very clearly about the potential for significant asset price inflation emerging as a consequence of a combination of excess liquidity and declining liquidity preference. I have emphasized this theme in predicting higher stock prices as well as highlighting the conundrum faced by the US Fed in exiting from its QE policy. Visible asset price inflation and excessive exuberance in certain sectors of the bond, stock and property markets are likely what initially spurred the US Fed to telegraph a possible "tapering" of its QE program. Indeed, it has become clear that the Fed considers the prospect of asset price inflation to be one of the main threats to the eventual success of the QE program. Indeed the threat of asset price inflation became a major policy issue in 2013, much as I envisioned.
Overall, my portfolio strategy, asset allocation and sector selection calls in 2013 were remarkably prescient. My biggest asset allocation calls which were to sell/short bonds, sell/short gold and to be overweight equities, and these worked very well. Furthermore, my stock sector and style selections were very prescient and added considerable alpha to portfolios.
2013 was a year of developed markets healing and emerging markets reeling. 2013 was a year in which there was a reversal of major macro trends including a stabilization of the European crisis, a major overhaul of Japanese economic policy, an acceleration of US economic growth and a sharp rise in long-term interest rates in the US and around the world. Those who stuck with investment themes that worked consistently in 2011 and 2012 such as long bonds and long dividend-oriented stocks did relatively poorly. By contrast, those who foresaw the tend towards accelerated growth and higher interest rates sold bonds and dividend oriented stocks and were able to capitalize on the outperformance of previously neglected growth stocks and small caps. Safe-havens such as gold which had been a stellar performer for almost a decade prior, collapsed in price, while risk appetites were awakened and stocks in sectors such as alternative energy (FSLR), clean energy (TSLA) and social networking (TWTR) rewarded investors handsomely for taking risk.
What does the future hold in store for 2014? In the coming days I will publish a summary version of my 2014 outlook on Seeking Alpha, while my detailed 2014 Outlook report, complete with stock and fund suggestions, will be made available to subscribers of my free newsletter.