U.S. equity markets finished 2013 in noteworthy fashion. The S&P 500's (IVV SPY)32% return was its 11th best since 1927. Not a single well-known market strategist expected the S&P 500 to close just shy of 1,850. In fact, when the strategists first made their market calls at the end of 2012, the highest price target for the S&P 500 was 1,615, some 13% below the year-end close.
What caused such a gross miss? Were earnings so much better than they had predicted? To the contrary, the average earnings estimate made back in 2012 for the year 2013 was $101. 2013 is now expected to register $99 in reported earnings when the dust settles.
Changes in valuation - the expansion of price multiples - drove the difference. Analysts expected the S&P 500 to trade for 16.1x earnings and instead the index closed 2013 trading for 18.7x earnings. Other valuation metrics registered similar increases.
Every broad-market valuation metric we track - and there are nearly 20 - show at best fair valuation and at worst gross overvaluation.
The economy performed to our expectations in 2013, though we underestimated the broad market's return. At this time last year we wrote, "these positives won't likely lead to a banner year, but more moderate returns." We were directionally right, but wrong on the magnitude. 2013 was very much a banner year.
We performed well too - our strategies rose over 30%.
Where does that leave us today?
Ten-year expected returns are in the low single digits. We aren't alone in expecting low long-term returns: GMO, which puts out one of the most accurate long-term forecasts each quarter, predicts negative returns to U.S. equities over the next seven years.
As for 2014? Our best guess is that equity markets will rise again as the economy continues to grow and operating margins expand in the latter portion of this economic cycle. Returns should be more modest as price multiples are already high. Even Wall Street's preferred metric, the forward P/E, is 10% above its 10-year average and 20% above its 35-year average.
Though, at this point, there is actually a "risk" to under-invested managers. In typical end-of-bull-market fashion, investors will likely fail to comprehend that profits are approaching peak levels and place unduly high multiples on those earnings. So long as the economy continues to expand, markets may well rise another 20% to 30% over the next two years in this scenario.
We have forecasted modest 10-year returns for the last couple of years and yet the market has risen an average 24%. It will take another eight to ten years to be proven wrong or right. For now we say that returns have been pulled forward and thus future returns - based on the logic of math - will be even lower.
With each year that passes, we come closer to the inevitable: recession, bear market, and with it, steep losses for the unprepared.
And yet, we remain confident in our positioning. This has everything to do with the composition of our portfolio, our expectation for the economy, and the fluidity inherent in our investment process.
We do not own the market. We own a small number of exceptional businesses. What do you own?
We expect the U.S. economy to continue to grow and the Federal Reserve to maintain its highly accommodative stance for a couple more years. The vast majority of market declines are sustained during recession, which fortunately appears to be a low probability event at this time.
Our investment strategy, implemented through our sound process, has inherent flexibility. In near automatic fashion, our process shifts our positioning as valuations change, macro risk rises and the opportunity set evolves. That, combined with our prowess in security selection, should limit our downside as this market cycle eventually comes to a close. What does your process do?
As markets stride toward new all-time highs on valuations that have historically coincided with other market peaks, it would be wise to count your blessings and better still, count your managers and understand their strategies and processes. This is literally the kind of market environment where the tide lifts all boats. But we are on the trajectory of what may become the third asset bubble in twenty years that will inescapably pop. Now is the time to review your positioning and plan accordingly.
As the African proverb says, "when the music changes, so does the dance." We expect to thrive when the music stops. For now, its the same old song and dance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.