By John Frankola
Despite a number of negative headwinds during the first quarter of 2014, the S&P 500 Index (SPX) set another record high and closed the quarter with a modest return of 1.8%.
The stock market continued its advance despite weaker than expected economic indicators (largely blamed on severe winter weather), the Federal Reserve curtailing its stimulus program, the Russian annexation of Crimea, sluggish growth in China, and concerns about stock price valuations.
The table below shows the performance of major equity indices for various time periods.
While the stock market's advance in the first quarter was considerably less than the pace of the last several years, investors generally remained positive about equities.
Global economic growth is expected to improve from 2.9% in 2013 to 3.6% in 2014. S&P 500 Index companies' earnings are forecasted to increase by 10.9% in 2014. Corporate balance sheets are relatively strong, which supports higher dividends, share buybacks, and acquisitions of other companies.
Although the Fed has begun to taper its bond buying program, it has also signaled to the markets that it will remain accommodative for sometime in order to reduce unemployment and keep the economy moving forward.
With the stock market advancing significantly over the past year, there is some concern that stock prices have moved to a level which makes company valuations less attractive. The S&P 500 is currently trading at 15.2 times its 12-month forward earnings, which is about 10% above its 10-year average.
Although stocks in general do not appear to be significantly overvalued, it has become much more difficult to find good companies at inexpensive valuations.
While not as ridiculous as during the dot.com era, the valuations of a number of "hot stocks" appear to be at speculative levels. Amazon (AMZN), Facebook (FB), Linkedin (LNKD), Netflix (NFLX), Tesla (TSLA), and 3D Systems (DDD) all have price/earnings (P/E) ratios that are over 50. Fireye (FEYE), Pandora (P), SolarCity (SCTY), Twitter (TWTR), Zillow (Z), and Zynga (ZNGA) each have multi-billion dollar valuations, but are all losing money.
In March, when the S&P 500 was up 0.8%, Facebook, Tesla, Pandora, and Zynga each declined more than 12%; Fireye and SolarCity fell by more than 25%. While most of these companies still have big price gains for the past year, it is probably healthy for investors to see some of the risk associated with chasing these high-fliers.
At this point in time, the overall market seems to be fairly valued and market speculation seems to be limited to a relatively small group of stocks. In this environment, it is probably best for equity investors to have fairly modest expectations for the rest of 2014.
The current bull market which began on March 9, 2009 has passed a number of milestones. (A bull market is commonly defined as a period without a 20% correction.) The 177% increase in the S&P 500 Index makes this the fourth strongest bull market on record.
With a duration of more than five years, it is now the fifth longest bull market since the S&P 500 Index was created in the 1920s. In addition, the S&P 500 has gone two and a half years without a 10% correction.
To the surprise of many, fixed income markets had a strong quarter. The Barclays Aggregate Bond Index, the broadest benchmark of the U.S. bond market, generated returns of 1.8% for the first quarter of 2014. During the first quarter, interest rates declined as economic indicators showed slower growth than expected.
The yield on the 10-year Treasury bond ended the quarter at 2.72%, down from 3.03% at the end of 2014. Fixed income investments, especially those with longer maturities, appear to be unattractive due to the current low interest rate environment and the risk associated with a possible increase in rates over the next several years.
In looking back over the bull market of the past five years, it is possible to witness a significant change in investor sentiment. Following the stock market crash of 2008-9, many investors lost faith in the financial markets and equity investing. With the relatively steady advance in the stock prices over the past several years, investor confidence has largely been restored.
While the market can continue to move higher in the current environment, it is important to remember that stocks have risk and markets can be volatile. Since short-term market moves are largely unpredictable, it is essential that investors maintain an asset mix that is appropriate for their objectives and risk tolerance, utilize diversification to control risk, and own investments that are reasonably valued.DISCLAIMER: The investments discussed are held in client accounts as of March 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.
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