Fourth Quarter 2013 Letter to Clients

Five “Inevitable” Assumptions That Proved to Not Be So Inevitable in 2013

There have been quite a few investment assumptions in the conventional wisdom in recent years about things that were just “going to happen” that, in fact, proved to be mistaken assumptions in 2013. So, with nary a trace of “we told you so” in our voices, we examine now five of these assumptions in more detail:

1. The market is too high and is due for a correction. We should take some money off the table.

Going into 2013, the conventional wisdom among investors, and among most of the “experts,” was that stocks, near their all-time highs, were due for a downturn. Fearing this, many investors pared back on their stock exposure and put the proceeds into bonds.

Stocks, alas, did not cooperate, instead returning about 30% on the year – their strongest year since 1997. Meanwhile, bonds were essentially breakeven for 2013. Every dollar that investors took out of stocks heading into the year in fear of a downturn would have been worth $1.30 at year end had they stayed invested. From that point, even a 20% bear market would leave the investors who stayed the course ahead of those who pulled their money out of stocks and “played it safe.”

No one could have foreseen this – and that’s really the point. Guessing games about the short-term direction of the market are about as successful as guessing games about the winning Powerball lottery ticket. But the downside risk of guessing wrong is a lot worse!

2. With all the money the Fed is dumping into the financial system, inflation is going to soar.

Of all the “inevitable” assumptions we heard kicked around following the 2008-09 financial crisis, none was more prevalent than the belief that easy money was going to put inflation into hyper-drive. And when the inflation rate ticked up to 3% in 2011, many investors saw this as a sign that the long-awaited inflation spike was occurring:
Only it didn’t happen. The annual inflation rate fell in 2012 and fell again in 2013, dropping down to just a little more than 1%. The reasons why inflation didn’t work its way into the financial system are the subject of a great deal of debate among economists, which further underscores our point: The U.S. economy is far too complex for anyone to reduce it to “input A will therefore lead to outcome B.” Investors who succumb to this kind of thinking usually end up getting burned.

3. With inflation set to soar, we should invest in gold.

This is the second part of the assumption many investors made when the Federal Reserve turned on the money printing press following the 2008-09 financial crisis. Since inflation is going to be spiking, then we need to invest in an inflation hedge. And gold is the best inflation hedge.

Even in inflationary times gold has proved to be a lousy inflation hedge, because it performs inconsistently in such environments and thus affords no real assurance that it will protect purchasing power. The fact that inflation didn’t spike in this case makes it an even more bitter pill for gold investors. Here’s a look at the performance of the S&P 500 index (red line) vs. gold (blue line) for the past three years:
Investors who loaded up on gold traded a 50% stock market gain for a 10% loss – a whopping 60% performance difference in only three years’ time. Perhaps even more confounding is the dilemma they face today:

What now?

4. It will take a generation for stocks to recover the losses they experienced in 2008-09.

One of the parallels drawn most frequently during the financial crisis was the amount of time it took stocks to retrace their old highs after the 1929 market crash. It wasn’t until 1954 (you read correctly!) that the Dow regained its 1929 high, a fact that the many bearish experts on the cable news shows couldn’t point out enough in 2008. “It won’t be a ‘v-shaped’ recovery this time,” was the constant refrain.

Oh well. Stocks took off from their low in March 2009 and, despite the occasional setbacks along the way, haven’t looked back since. The Dow regained its October 2007 high in early 2013, a mere six-and-a-half years after the worst financial crisis in a century. And note the pronounced “V” in the recovery in 2009:

5. European stocks will be dragged down by the Eurozone mess. Emerging market stocks are a better bet for international exposure.

With the developed economies in the Eurozone bogged down in the monetary crisis that plagued the continent from 2009 through much of 2012, the experts and analysts said to avoid the continent altogether and bet instead on emerging markets stocks, which had soared coming out of the financial crisis. As a result, many investors pared back on their exposure to stocks in the developed European markets and overloaded on emerging markets stocks.

Predictably, the conventional wisdom was, yet again, wrong. The MSCI EAFE index of developed foreign stocks soared in 2012 and 2013, gaining more than 40% cumulatively. Emerging markets stocks, in contrast, actually suffered slight declines for the period.

This isn’t an indictment of emerging markets stocks, which have been solid contributors to a diversified portfolio in recent years, gaining almost 15% a year over the past five years. It merely highlights the fact that the conventional wisdom about where to invest that sounds so sensible in advance usually proves to be completely wrong in hindsight!

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Get ready…Dow 30,000 is coming!

Now, before you think we have completely abandoned our investment principles and begun making market predictions, we hasten to add that we don’t know when Dow 30,000 is coming. No one does.

But that rather large-looking number is not as far away as you might think. If stocks achieve anything like their long-term historical average of 10% in the coming decade, we would likely see the Dow cross the 30,000 threshold in about seven or eight years. Of course, we could also have a decade like the 2000s and end up about where we started it, with the Dow around 16,000.

But indulge us for a moment and assume Dow 30,000 is on the mid-term horizon. Now imagine what the financial press will have to say about the journey along the way. The news cycles will undoubtedly focus, depending on the market environment, on the “stratospheric gains” or “triple-digit losses” that stocks are experiencing at a given time. These claims will be based on point comparisons, as opposed to percentage comparisons, as we have seen time and again in recent years when the media has reported stocks suffering one of their worst-ever “point declines,” such as in August of 2011.

In short, the financial media will make every step of that journey feel like a one-way trip to bubble town. So we bring this to your attention now because it is important to keep in mind that the point milestones the market reaches are all relative. At current levels, a one-day decline of 3% in the Dow (which is a bad day but not an historically bad day) would equate to a point decline of about 500 points. Such a point decline in early 2009 would have equated to a decline of about 8%. Such a decline in 1987, which happened in October of that year, equated to a 20% drop. And such a decline in the 1930s would have wiped the market out!

One day the Dow will undoubtedly top 100,000, then a half million, then a million (would that we were all there to see it!). It is the nature of the stock market to move ever higher over the long term. Don’t let the financial press make that journey an unnecessarily stressful one for you along the way.