The Markets	12/31/13   Close	09/30/13   Close	4th  Qtr.  Change	12/31/12   Close	12 Mo. Change	YTD       Change
Dow	16,577	15,130	+9.56%	13,104	+26.50%	+26.50%
NASDAQ	4,177	3,771	+10.77%	3,020	+38.31%	+38.31%
S&P 500	1,848	1,682	+9.87%	1,426	+29.59%	+29.59%
MSCI EAFE	1,916	1,818	+5.39%	1,604	+19.45%	+19.45%
10-yr Treas. yield	3.03%	2.62%	+0.41%	1.76%	+1.27%	+1.27%
Fed funds rate	0 to.25%	0 to.25%	n/a	0 to.25%	n/a	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

The stock markets finished a remarkably strong year, with the Dow setting 52 new highs and the S&P 500 having its best year since 1997. Even Europe showed some life, with both manufacturing and services in the Euro zone showing growth and slight inflation (which is good news, offsetting fears of damaging deflation). Household net worth grew to $77 trillion in the third quarter, a new record, boosted by stock market increases and housing prices. The final revision for third quarter GDP growth was raised to 4.1% on stronger consumer spending. However, much of the rest of the increase came from increased business inventories, which could crimp growth in the fourth quarter. On December 27, the benchmark 10-year Treasury bond closed over 3% for the first time since July, 2011 and gold suffered its worst performance since 1981.

Mutual funds focusing on US stocks had inflows for 2013 of over $60 billion, which is the first yearly gain since 2005. This is still a trickle given the market’s strong gains, and investors withdrew $451 billion from stock funds from 2006 to 2012. At the same time, exchange-traded US stock funds took in $353 billion from 2006 through 2012 and over $90 billion in 2013. Still, the lukewarm response from individual investors could limit the stock rally going forward.

Housing seems to have finally found its footing. New home sales were at their highest level in five years, with median prices at record levels and inventories of new homes at low levels. Housing starts remained strong to meet that demand and sales conditions were the best in eight years. Existing home sales also showed stronger prices, with a 9% increase, and low inventories but the rate of sales increase has slowed considerably. Local markets were mixed, with Zillow reporting that 10 of the 50 largest metropolitan areas now have prices above the prior peak, but 1,500 cities of all sizes still have prices 25% or more below peak levels. The recent rise in interest rates sent mortgage refinancing to a five-year low and overall mortgage applications fell sharply.

The market not only took in stride the Fed’s December announcement that it will start a $10 billion reduction in monthly bond-buying (the dreaded “taper”) but embraced the Fed’s concurrent pledge to keep interest rates low even longer than before. The easy money era has not ended, as the Fed is still buying $75 billion of bonds each month and Janet Yellen, the presumptive new Fed chairman, indicated that easy money policy will continue even after unemployment or inflation thresholds have been reached. After ending the October government shutdown with a 90-day deadline for further action, Congress reached a two-year budget agreement that put an end to the automatic “sequester” spending cuts, increased employee contributions to federal pensions and ended, at least temporarily, long-term unemployment benefits. The net result was a $23 billion spending reduction, although neither side found a lot to love in the agreement. In what could establish an important precedent, a federal judge ruled that Detroit could declare bankruptcy, and now a resolution must be reached with its employees, retirees and bondholders.

Unemployment fell to 7% but more important were the rebound in the labor participation rate off 35-year lows and a five-year low measure for underemployment; in other words, more workers are finding jobs that fit their skill level. Hours worked, consumer incomes and wages showed slow but relatively steady growth, helping consumer spending. Industrial production (manufacturing, mining and utilities) surpassed pre-recession levels and worker productivity rose 3%, the largest increase in four years. And in another sign that we are moving on from the recession, the government sold its last shares of GM, realizing a $10 billion overall loss on the bailout.

Looking Forward

With the Fed successfully juggling market reaction with the undeniable need to back off of quantitative easing at some point, the immediate question of the impact of easing has been answered. Part of the muted reaction was the Fed’s stated intention of keeping interest rates low for even longer than previously indicated. Of course, the Fed’s main tool in keeping rates low is to buy securities, so easing could go on under a different name.

There still remains a lack of clarity on when and how the Fed will take the next step in tapering its easy money programs. Talk of various “bubbles” is gaining steam, as is the notion that bursting bubbles are always painful.

We also dug up the last four “Looking Forward” pieces. There is no attempt or intent to be predictive in these segments; they are only meant to recognize significant economic and political challenges.

• Fourth quarter 2012: the fiscal cliff (came and went with a whimper)
• First quarter 2013: can the market hold its rally (a big yes)
• Second quarter 2013: will interest rates rise and will the Fed taper (a little, on both points)
• Third quarter 2013: the government shutdown (resolved, at least until the next debt ceiling debate)

On the one hand, time has healed many of the wounds of the recession, the economy is on much sounder footing and small seeds of cooperation have been sown in Washington. On the other hand, it is definitely not a time to be complacent, and an unexpected economic or geopolitical shock could easily disrupt the recovery.

Our Portfolios

Occasionally investors are faced with an environment where everything seems “cheap” – stocks have fallen more than 10% from recent highs, bond yields have gone up, real estate prices have leveled off or fallen, etc. Unfortunately, this only happens when there are real and deep problems pushing prices down. The most recent, and probably best, example is 2009.

This is the most difficult time to take a deep breath and buy, and by the time the problems have subsided enough to an investment seem less risky prices have rebounded.

Likewise, we are now at a point where everything seems expensive, or at least not cheap – stocks are at record highs, bond yields have gone up a bit but are still historically low, real estate has recovered just as mortgage rates have nosed up. So, where does a bargain-hunting investor go these days?

Here are a couple of obvious underperformers from 2013.

• Gold – First down year in the last 13 years, worst year since 1981, there are still plenty of doomsayers who think it’s the last refuge as a store of value.
• Emerging markets – The index was down nearly 10% while developed international stocks were up nearly 20%. And the emerging economies still have the highest growth rates.
• Commodities – Weakening demand and growing supply drove prices down almost across the board. But underlying demand and some bad weather could turn that all around.
• Mortgage REIT’s – Since these vehicles borrow large amounts of money and use that borrowed money to buy mortgage securities, they were clobbered when rates jumped in May and June. Rising mortgage rates could help them out and they still pay a high dividend.

Having identified some relative bargain areas, we must be making portfolio adjustments to take advantage of these opportunities.

No, for three fundamental reasons.

First, things are often cheap for good reason, and with the possible exception of emerging markets, these had run up beyond their fundamental value. In other words, they may have just returned to a more reasonable level. Second, our diversified portfolios have maintained exposure to most of these areas (very little to mortgage REIT’s, which are financial alchemy) and will continue to do so. Third, and most important, to commit a disproportionate portion of a portfolio to focused sectors or investment vehicles greatly increases risk that is unlikely to be offset by higher returns. A speculative investor may jump into investments such as these, and there will surely be some cocktail party bragging if any of them soars, but we continue to believe that a widely diversified portfolio is the best way to achieve long-term goals.

Polish the Crystal Ball

Two of the great dilemmas in investing are that we have short memories and that hindsight is 20/20. This combination leads to hand-wringing over missed opportunities and blame over how the obvious could have been overlooked.

Of course, looking back further to what we thought would happen and then what actually happened is much more useful. So, courtesy of the Wall Street Journal, here are some of the biggest surprises of 2013.

• Netflix soared – Netflix had been pretty much left for dead before becoming the best performer in the S&P 500 in 2013. Most analysts (30 out of 36) had the stock rated either “hold” or “sell”, an overall bearish consensus.
• So did stock markets – Barron’s poll of investment manages in late 2012 indicated that the number of managers who expected the market to fall outnumbered those who were positive. At no point in 2013 did the S&P 500 fall more than 5% before resuming its climb. Oops.
• Housing took off – The rate for 30-year mortgages rose over 1% and that increased the cost of financing a home purchase. But housing prices kept rising in contrast to the predictions of a decline. By one measure, prices were up 5% nationwide, with increases of 15% in Florida and 23% in California.
• Gold plummeted – US government debt continued to climb, there was political dysfunction and Detroit filed for bankruptcy – all signs that we are on the verge of disaster, an environment in which gold should flourish. Instead, gold dropped 28%.
• Japan boomed – Money managers “wouldn’t touch Japanese stocks with 10-foot poles”. Then Japan instituted expansionist monetary policies and the Nikkei index was up over 50%.
• Emerging markets drooped – In the same Bank of America survey, money managers loved emerging markets as much as they hated Japan. Despite economic growth, emerging markets stocks actually fell, even including dividends.

Those are some pretty big misses.

But we simply can’t resist trying to predict markets. According to the Associated Press, here’s what Wall Street money managers expect for 2014.

• The S&P 500 will be close to flat, with gains of 2% to 4%.
• Corporate profit growth will slow from 11% in 2013 to around 8% in 2014.
• Goldman Sachs sees a 67% chance that stocks will decline 10% or more in 2014.
• Gold and other commodities will struggle.
• International stocks will be the place to be, with Europe being particularly attractive.

Considering the woeful accuracy of market predictions, I wouldn’t bet the farm on any of these 2014 ideas. But don’t forget them when we’re looking back this time next year.