Winter Letter {Part I}

Today we will begin posting our most recent letter that we sent out to our clients last week.

US Stocks were spectacular last year.  Major averages like the S&P 500 posted returns north of 30% when dividends are factored in.  Developed world markets experienced returns exceeding 20%.  Emerging markets however declined, as did most strategies related to commodities and income.  Regarding the latter, the rise in interest rates from historic lows caused principle declines, which offset their income returns. Asset allocation strategies according to JP Morgan last year returned 14.9% *

We have stressed over the past several years our belief that stocks were cheap.  A year ago many investors thought that 2012’s above average returns meant that 2013’s gains would be muted.  That was not our thinking. With the S&P 500 beginning the year at 1,426, we told you in last year’s letter that the index had the potential to trade between 1,490 and 1,700. We have held a variant view for the past several years that from economic standpoint things were getting better.  Last year we felt that better economic performance coupled with advances in technology and productivity would allow corporate profits to continue growing which in turn would enable the stock market to continue its advance.  We were low in our targets as the S&P 500 finished trading the year at 1,846. Though we didn’t quite have the magnitude of the advance in our calculations, we were not surprised that stocks showed strong positive returns.

I believe that the events of 2007-2009 can be best described by comparing then to what happens when a heavy object such as a large rock is thrown into a still pool of water.   What happens is that the mass of the object displaces the liquid.  As soon as that occurs though, the water rushes back in to fill the gap.  After a period of roiling around, the water returns to its previous level.  Absent another disturbance it eventually calms down.  The economic crisis that roiled the globe in those years was that large object.  The crater it left came largely from the collapse of financial institutions related to housing and the subsequent debt shock to many countries around the world.  The worst of that seems to be passing.  There is not yet what we would call a complete recovery.  However, from an economic standard, we are closer now to normal than any time since.  That is now reflected in stock prices.  On the recession’s eve in October, 2007 stocks traded with a Price to Earnings ratio {PE} slightly higher than 15 but within their historic range of 14-16 times earnings. Stock PEs are again trading within that historic range.*  We seem to have finally climbed away from the edge of the abyss.  Despite the protestations of many, the American ability to pick ourselves off the canvas seems to be alive and well. For all the gut wrenching and worries produced in the last six years, by my calculations and including dividends stocks have returned on an annualized basis something close to 5%.  The question to be asked now is where does that leave us? 

* Source of statistics:  JP Morgan Asset Management,“Market Insights, Guide to the Markets, As of December 31, 2013.”

As of this writing Mr. English held positions in ETFs related to the S&P 500 in client and personal accounts.