By Jeff Kautz
Stocks continued to reach new highs throughout 2013, notably with the S&P 500 Index closing the year with an impressive 32.4% annual gain – its strongest in the past 15 years. But what are the chances of this bull-run continuing, and how should investors be approaching 2014?
What to expect this year: repeat or reversal?
A bullish argument for 2014 can certainly be put forward. Equities may not appear overly expensive – the S&P 500 ended the year at 15.5 times forward earnings per share – and, at the same time, companies remain flush with cash, and earnings continue to be strong.
However, on the other hand, we remain slightly more cautious; the cyclically adjusted Shiller price-earnings ratio was 40% higher than its historical mean at year-end, suggesting stocks may well be significantly overvalued. Earnings growth estimates of 8% in 2014 and 10% in 2015 may also prove to be too optimistic. Real top-line growth has not fully materialised for most companies.
In addition to this, there continues to be plenty of macro-economic risks in the marketplace that could easily spark a sharp rise in volatility with any sign of deterioration from China’s economic slowdown and Europe’s continued financial woes, to the Middle East’s heightened political turmoil. The long-awaited US economic recovery finally appears to be displaying real, if still somewhat tempered, indications of growth. But there remains lots of less rosy news to be concerned with as well, including limited wage growth and ongoing skepticism about improving employment data being partly undermined by stubbornly low labour force participation rates and questionable quality around new jobs being created.
The value perspective
Yet caution does not simply mean bearish. In fact, we believe equities continue to be the most attractive long-term choice for investors, especially when compared to cash and fixed income alternatives. For us, the key is to understand downside exposure first and foremost, before evaluating upside potential.
In our view, the market’s run since 2009 has been firmly led by low-quality stocks (characterised as more volatile, leveraged and what we view as generally lower-quality issues), notwithstanding some sizeable, sporadic dips along the way. This trend looks a bit long in the tooth compared to past cycles.
Instead, we believe the best opportunity lies with higher-quality stocks – with strong balance sheets, cash flows, earnings stability and competitive position. Our research has shown that these types of companies have delivered the strongest risk-adjusted returns long term, and we believe they offer the most attractive reward/risk potential in today’s market.
Hope for the best, prepare for the worst
Therefore, we start 2014 with much the same view we had throughout last year: happy to participate in market gains, while actively mitigating portfolio risk exposure.
Stocks could have another strong year, but markets have tended to revert to the mean over the long term, a fact investors sometimes forget until it is too late. Investors should ask themselves how much downside exposure they are comfortable holding in this type of environment.
We believe it makes more sense to try to protect assets in the event markets suddenly become more volatile, even if this means conceding some return on the upside. No one is unhappily surprised by unexpected gains. The same is not true for unexpected losses.
Jeff Kautz is chief investment officer of Perkins and portfolio manager of the Perkins Mid Cap Value and Perkins Value Plus Income strategies
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