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2013 was a banner year for the stock market. On December 31st, the Dow Jones closed at an all-time high for the 56th time of the year, ending with a total return of over 27%.

While stocks had their best year since 1997, the economic news did not seem to support such a dramatic increase in stock prices.

  • At the beginning of 2013, Wall Street estimated 8% earnings and dividend growth for the year. Dividends met expectations, but earnings growth was a disappointing 4.5%.
  • Sub 2% GDP growth continued for most of the year, and while the unemployment rate fell, much of the improvement was a result of frustrated workers giving up their job searches and thus no longer being counted in the official unemployment rate.
  • Sequestration hit in 2013, reducing Government spending and dragging down already slow U.S. GDP growth by about 0.5% for the year.
  • Interest rates, which are typically inversely correlated with stock prices, increased significantly. The yield on 10-year U.S. Treasury bonds began the year trading below 1.85%. After the Fed began talking about tapering Quantitative Easing (QE), the 10-year started its upward climb to end 2013 just above 3.0%.
  • The Government shutdown in mid-October threatened to derail economic recovery and highlighted growing dysfunction in Washington.

Why Was the Market Up 25%+?

With so much lukewarm economic data, how could the markets have gone up over 25% in 2013?

As our clients and readers of our blog know, we use several proprietary statistical models which have been useful for us over the years to determine the valuation of individual stocks and the stock market as a whole.

Our proprietary Dow Jones Industrial Average (DJIA) model is one of those tools. This model analyzes the interplay among DJIA earnings, dividends, and interest rate data going back to 1960 to compute a fair value for the market.

For those of you with a background in statistics, the model has a very high R-squared at around 0.91 and statistically significant p-values. In other words, the variables used are highly correlated with the movement of the DJIA price. More importantly, we have found that this model has done a good job of estimating where stock prices are headed over the coming year.

Below is a chart of the DJIA model as of the beginning of 2013. The red line represents the DJIA price with the blue bars indicating where the model predicts price should be. The checkered blue bar is the estimated level for the coming year based upon estimated dividend and earnings growth as well as estimated interest rates.

(click to enlarge)
Dow Jones Industrial Model: Beginning of 2013

The model predicted that stocks were undervalued throughout the mid-1980s and early 1990s before getting way overvalued in the late 1990s. Prices corrected in 2002-03 and followed closely from 2004 to 2007.

After the financial crisis of 2008-09, the DJIA plummeted to well below it's predicted value. Even with prices moving sharply higher from 2009 to 2012, the red price line stayed below the blue value bars.

To begin 2013, the model predicted that - assuming earnings and dividend growth of 8% and an increase in interest rates to 3.0% - the market was undervalued by just under 26%.

What happened in 2013?

The surprisingly strong performance of stocks in 2013 consisted of two driving forces. One was the dividend and earnings growth for the year. The second and most important was a catch-up of prices to valuations, which had been present since the subprime crisis of 2008-09.

2014: Can The Market Do It Again?

With 2013 behind us, investors are now asking if the market can do it again. Based on 2013 year-end data, our DJIA model is signalling that stocks are about fairly valued.

(click to enlarge)
Dow Jones Industrial Model: Beginning of 2014

With stocks at fair value, it is unlikely they will repeat their 2013 performance in the year ahead. However, that does not mean stocks are headed for a major correction.

The market is a discounting mechanism, which means it will price in what it believes sales, earnings and dividend growth are likely to be in the coming year.

Our model accounts for this discounting in its predictions. With prices at fair value - the expectation for stocks in 2014 is likely to be very similar to the rate of growth of dividends and earnings of the 30 Dow Jones companies.

Dividends, Earnings, & Interest Rates in 2014

Earnings

Wall Street's current view is that earnings will grow nearly 12% in the year ahead. The view of the DCM Macro Team is that earnings will grow by about 10%.

Despite sub-par economic growth and political stalemate over the past five years, companies have not been merely treading water. They have slimmed down dramatically and technology has exploded. That means that these companies are able to squeeze a lot more out of $1 of revenue than they could pre-2008.

Dividends

Dividends in our valuation model are of even more importance than earnings to long-term stock price appreciation. Dividend growth for 2014 is expected to be slightly higher than earnings growth. We anticipate growth for the DJIA to be around 11%.

Interest Rates

Our Macro Team expects inflation will remain subdued and 10-year Treasury bond interest rates will likely remain within a range of 2.5% to 3.5%.

If 10-year Treasury Bond interest rates rise to 3.5% and dividend and earnings growth reaches 10%, our proprietary DJIA model estimates that stocks are undervalued by approximately 9%. This is shown by the blue checkered bar on the above chart.

As long as both earnings and interest rates remain favorable, the market could be in for another strong year. While another 25%+ performance is unlikely, we remain optimistic that the bull market will continue in 2014.

Source: Dow Jones 18,000: Here's How We Get There