When we decided to ride the central bank liquidity wave in 2013, we knew there was a chance the market could have a pretty good year, but like most investors we were pleasantly surprised with the gains that the U.S. stock market delivered. Including dividends, the S&P 500 Index soared by 32%, well in excess of what even the most optimistic prognosticators envisioned at the start of the year.

Upon closer examination, not all stocks markets, nor asset classes, fared as well. While international stocks in developed markets gained roughly 23% (MSCI EAFE Index), emerging market stocks closed out the year with losses of close to 2% (MSCI Emerging Markets Index). It was also a rough year for holders of government bonds and other interest rate sensitive sectors, as the U.S. aggregate bond index lost approximately 2% (Barclays Aggregate Bond Index), with longer-dated bonds fairing far worse as yields normalized across the globe. Broad commodity indexes were among the worst performers, losing roughly -9.5% (Dow Jones/UBS Commodity Index) over the course of the year.

What Lies Ahead?

While 2013 ended with a momentum driven rally for U.S. stocks, investors must recognize that the year is now in the rearview mirror. It’s time for investors to assess what may lie ahead for the investing landscape. Here’s how we are viewing the start of 2014…

Economic Landscape Mostly Encouraging

2014 starts with a major question mark for all investors. The issue comes down to an inflection point in the U.S. business cycle, and what that means for the Federal Reserve in regards to its large scale asset purchase program (LSAP) -- also known as quantitative easing (QE).

The good news is that the economic landscape in the developed world appears to be picking up. Last year the U.S. economy was very resilient as it found a way to grind through the fiscal cliff, the sequester, and another round of budget negotiations that dampened confidence in the recovery for a brief period. This year, with some momentum behind it and less of a fiscal drag in store, the U.S. economy appears poised for further improvement (barring an unforeseen shock). European economies also appear to be slowly healing, though with large divergences between Germany and France starting to appear, and a periphery that continues to slowly lift from the depressionary ashes. The one soft spot in the globe still involves emerging markets countries, where China is muddling through a rebalancing phase and many other parts of the region are suffering from higher rates, weak commodity prices, and higher inflation than what is found in the developed world. Interestingly, the region may get a lift from improving growth in developed markets, which would be a reversal of the dynamic of the past decade that saw emerging countries act as the engine for global growth.

Passing Through the Goldilocks Zone?

Over the past five years, very slow economic fundamentals may have cast considerable skepticism over the rally off of the 2009 bottom, but they also drove the central banks around the world to open up the monetary spigots in an attempt to boost growth rates. In hindsight the environment we’ve been living through has been goldilocks for risk assets. The odd mix of slow but not recessionary growth rates, flush liquidity, and plenty of doubt ended up being the perfect recipe for risk assets to explode higher.

This year many economic fundamentals appear poised to break to the upside. Third quarter GDP was over 4% last year, and though the fourth quarter may have reversed course a bit due to the budget debate, the economy seemed to accelerate again late in the fourth quarter. Here’s the conundrum: Better fundamentals are typically considered good for markets as they are good for sales, earnings, and the overall wealth affect. However, if better growth compels the Fed to withdraw stimulus more quickly, how can anyone confidently predict how markets will react?

Overall, liquidity will still increase this year, even if it’s to a lesser degree. And even if that’s the case, the Federal Funds rate will likely remain near 0% well beyond any near-term improvements in the economy. Nevertheless, markets can be finicky and don’t always work off of absolute levels. Instead, they often respond to changes at the margin. The Fed has already signaled that it will reduce the LSAP program by $10 billion/ month, and the assumption is that as long as economic growth can stomach the reduction, they will continue to gradually wind the bond buying program down during the course of 2014. In other words, the rate of growth in their balance sheet is about to start slowing.

We don’t pretend to know exactly how markets will digest this change. It may be that the economy is ready to stand on its own two feet, and that the reduction of QE is a healthy byproduct of a better economy. Perhaps Chairman Bernanke has actually managed to create a virtuous cycle despite an army of critics that took every opportunity to trash the Fed and the unprecedented policies of the last few years. On the other hand, one look at a chart of QE and the S&P 500 reveals that every time the Fed has ended one of their previous QE campaigns (QE1, QE2, Operation Twist, etc.) the environment quickly turned more volatile for stocks. Rather than digging in to either the bullish or bearish camp, we acknowledge that it’s hard to have much conviction in a particular market direction at a time when the Federal Reserve is beginning to withdraw its experimental medicine.

Valuation is Now Expensive

We’ve repeatedly said that valuation is not a good timing indicator, but investors are foolish to ignore it at the extremes. For many months we’ve been writing about the dichotomy between absolute and relative valuation levels, with the conclusion that the market was neither as overvalued as the bears would state, nor as undervalued as many bulls believed. After the tremendous gains of the past few years, our proprietary valuation model is now firmly signaling that the market is overvalued. The model’s reading is something we have taken notice of recently, though its message is still not extreme enough to force major reductions in portfolio volatility. What it does imply is that the margin of safety in U.S. stocks has deteriorated markedly from what it was just a few years ago.

The message that comes through loud and clear from valuation is that now is not the time to throw caution to the wind and load up on portfolio risk. Instead, it might be time to begin pruning some of the robust gains that have accrued in recent years.

Technicals: Healthy Trends but Frothy Markets

Currently the U.S. and many other developed markets are in solid uptrends, while emerging markets, commodities, and many parts of the fixed income market now appear to be in down trends. The old market adage is that “the trend is your friend.” If the positive technical story starts with very healthy trends in developed markets, the negative is that intermediate-term sentiment looks complacent, and in the near-term stocks appear to be in overbought territory. Like valuation, extended sentiment is not a great timing indicator, but it does serve a warning that the environment is ripe for change when an appropriate catalyst materializes.

Quant Models are Constructive

Our quantitative model for the U.S. equity market is still flashing mildly bullish signals, and seems to be in tune with many of the third party models we follow. This serves as a good confirmation that it is too early to get overly defensive.

Pullback to the Breakout Zone?

Given that valuation is in expensive territory, environmental indicators are flashing red, and there’s great uncertainty surrounding the stimulus, it wouldn’t be a surprise to see the market take a well-deserved breather sometime over the next few quarters. One possibility for a market pull back is a retreat to the point it broke out of last year. This wouldn’t be devastating, and would actually be a healthy technical development. On the S&P 500, this would translate to a retracement back to the neighborhood of the mid-to-high 1500’s, which is close to 300 points below current levels. Any correction close to that magnitude could be just what the doctor ordered to unwind complacency and take the edge off of extended valuations. As long as the business cycle doesn’t appear to be in danger of fizzling out, a material dip would likely set up a great buying opportunity for investors.

Portfolio Positioning

Business cycle conditions look solid, established trends seem to be in place, and the first few months of the year are typically very favorable for stocks. But with valuations extended, environmental indicators flashing red, and a major question mark regarding how the market will react to less liquidity, we believe it is time to begin migrating back towards neutral levels of portfolio risk.

In early January, we unwound some of the volatility that we had accumulated in anticipation of the fourth quarter rally. At present, portfolios are positioned modestly above neutral levels of volatility, and our current plan is to slowly reduce that volatility on rallies as the first quarter progresses. Some in the investment community believe that momentum may carry this market much higher before it falls. It may, but we would rather approach this inflection point cautiously rather than chase further gains. Warren Buffet likes to say that he tries to be fearful when others are greedy and greedy when others are fearful. It may not be time to be fearful just yet, but we’re past the point where one should be greedy.

© Pinnacle Advisory Group

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