Five years after the equity bull market started, U.S. investors returned to stocks in 2013, just in time for the best relative returns versus bonds on record.

Exchange-traded and mutual funds investing in shares took in about $162 billion, the most since 2000, according to data compiled by Bloomberg and the Investment Company Institute. At the same time, the Standard & Poor’s 500 Index climbed 29 percent, beating government debt by 32 percentage points, the widest spread since at least 1978, according to data compiled by Bank of America Merrill Lynch and Bloomberg.

Companies in the S&P 500 are worth$3.7 trillion more today than they were 12 months ago following a year when Federal Reserve Chairman Ben S. Bernanke signaled the curtailment of economic stimulus. The bull market, born at the depths of the credit crisis, enters its sixth year fueled by zero-percent interest rates and conviction among investors that it’s finally safe to own stock again.

Compound Growth

Including reinvested dividends, stocks lost about 1 percent annually from 2000 through 2009, data compiled by Bloomberg show. Adding the most recent four years brings the return to about 3.5 percent, compared with the 6 percent mean since 1900, inflation-adjusted data compiled by the London Business School and Credit Suisse Group AG show. The S&P 500 has returned 26 percent on an annual basis since March 2009.

David Fuller's view

Opinions aside, there is only one certainty about Wall Street as it enters 2014; stocks will not be as attractively priced as they commence trading next year as they were at the beginning of this year.  However, there is a strong probability that the US economy will be stronger in 2014 than it has been in 2013.  If so, that should be better for corporate earnings, at least on average.

Is this an equal tradeoff?  Your guess is a good as everyone else’s.  My guess is that it is less than an equal tradeoff because both US GDP and the global economy would really have to surge in 2014, to have any chance of offsetting higher valuations with higher corporate earnings.  Even if this happened, it would almost certainly push government bond yields to the upper range of next year’s forecasts.

In 2013, a considerable proportion of the growth in US corporate earnings came from share buybacks rather than additional revenue.  Will buybacks continue in 2014?  Yes, because it is more rewarding for corporate managements which have long positions in the shares of companies they run.  Moreover, managers of most large corporations also hold options to buy many more shares in these companies.  

Shares repurchased via corporate buyback programmes flatter earnings per share, which rewards remaining shareholders.  This policy also reduces the cost of dividend payments because there are fewer shares outstanding.  In our ultra-low interest rate environment, it has even paid for companies to borrow at current rates, not only to pay down higher cost loans, but also to reduce total dividend payments via additional share buyback programmes. 

If this sounds like a virtuous circle, it is, but these are of finite duration.  As interest rates eventually normalise at higher levels, the window on share buybacks will be considerably less attractive or even close.  Shares purchased via corporate option schemes will increase their supply, diluting earnings in the process.  When corporate managers conclude that their shares are not only overvalued but that their revenue will also fall, they will sell and take their profits.  Other shareholders will also sell.

This reversal of fortunes is unlikely to take place quickly.  However, it is somewhere out there, probably in our future over the next few years. I do not mention this as an immediate warning to take profits. I have yet to sell any shares in my personal portfolio.  Moreover, I have reinvested dividends in recent years and am likely to continue with this policy.             

I mention the above to help keep our analytical feet on the ground.  Veteran subscribers may have noted that currently fashionable US technology shares are bubbly to an extent not seen since 1999.  Yes, the excesses of today are far less than what we saw in the last tech bubble.  However, that mania is unlikely to be repeated in the living memories of those who were emotionally carried away as the last stock market secular uptrend was ending. 

There are far more little bubbles and few of them lead to serious manias because central banks and savvy investors are aware of the risks.  However, every small bubble also carries risks for unwary and particularly overleveraged players. 

As we prepare to toast our families and friends, and perhaps 2013’s stock market rewards on New Year’s Eve, let us also remember to be sensible: 

1) Keep an eye on Wall Street’s incredibly orderly trends of the last few months because when they lose their recent consistency, the risk of at least mean reversion towards their 200-day MAs and quite possibly the first 10 percent correction which we have not seen on Wall Street for the last 572 days, will have increased.  Remember, the US stock market is by far the most influential so when it corrects, sentiment elsewhere is likely to be affected, not least in other markets that have done very well this year.  Meanwhile, a small correction on Wall Street early in the New Year would be technically healthier than an extended upward acceleration during 1Q 2014. 

2) Where you have the good fortune to hold some runaway strong stocks, consider technical stops at levels which would indicate pattern deterioration.  It would also help you to keep an eye on the NASDAQ Buyback Achievers Index (DRBX Index), previously mentioned by Eoin.  To qualify for inclusion in this Index, shares have to buy back at least 5% of their free float over the last 12 months on a trailing basis.  Currently, a move below 7900 would be a warning and below 7700 we would see a loss of recent uptrend consistency. 

3) If looking to buy, consider ‘boring’, often cyclical laggards which are selling at approximately 10x earnings and offer a decent dividend.  While the bull is still alive and even after it has peaked, many of today’s cyclical laggards will outperform.