Views on the Market’s Rise in 2013 (written March 2013)

The press has made much ado over the stock market’s rise so far this year. Many investors who have little stock exposure ask if they can still add it to their portfolios, or whether things have risen too far, too fast. Others have become more bullish based on the same trends.

This post addresses why these may be the wrong questions to ask when it comes to your financial well-being. Once we have addressed how to view markets relative to your own financial situation, we will have some fun taking the temperature of market strategists, knowing that no one really knows where the market will end the year!

  • Personal Rate of Return vs. Market Rate of Return
  • Market Strategist Overview
    -Reasons the Stock Market Could Decline
    -Reasons the Stock Market May Continue to Rise
  • Summary

Personal Rate of Return vs. Market Rate of Return

There is so much focus in personal finance on market rates of return that we frequently neglect the fact that our savings rate is vitally important to meeting our financial goals.

There are two components to growth in an investment portfolio:

  1. Savings from the investor
  2. Growth in assets from investment performance

If you have started a regular savings program and stuck to it over your working career, then market fluctuations will have far less impact on your portfolio balance and therefore on your life. If you start your savings program early and stick with it, then you are much less dependent on market returns to do the heavy lifting in growing your portfolio.

An example will illustrate.

Salary Savings as % of Salary Savings per Year Years of Investing Rate of Return Account Value at Age 65
Sally Saver $100,000.00 10% $10,000 40 0.0% $400,000
Sally Saver Invests $100,000.00 10% $10,000 40 6.0% $1,547,620
Sally Slacker $100,000.00 2% $2,000 40 0.0% $80,000
Sally Slacker Invests $100,000.00 2% $2,000 40 6.0% $309,524

Sally Saver got busy at age 25 and saved 10% of her salary every year. Even if she earns no rate of return on her portfolio, it grows to $400,000 at the end of 40 years. If she invests and obtains a return of 6% annually, she grows the portfolio to $1,547,620. The investment return clearly added a lot to her retirement nest egg, but so did her savings.

Sally Slacker also saved, but not nearly as aggressively—only 2% of her salary annually. With no portfolio return, her savings only grow to $80,000 after 40 years. Of course, she does much better if she can also obtain growth of 6% from market returns. Then her portfolio value after 40 years comes to $309,524. But even though she had exactly the same salary and market returns as Sally Saver, her final portfolio remains only 20% the size of Sally Saver’s account.

I know financial obligations can get in the way of savings (particularly if there are children or other family members to support). But to the degree one can determine one’s financial future, it is critical to do so. I think of this as a “personal rate of return” which you and I can control far more than we can influence portfolio results.

If you instead view the performance of your portfolio as the primary driver of your wealth, then you may be vulnerable to chasing market trends, taking stock tips from your friends, or whatever method catches your fancy. This can be expensive, which works against keeping gains in your portfolio, and it can also lead to emotionally driven investment decisions that don’t pay off. For your financial well-being, please become a Sally (or Sam) Saver as soon as possible if you are not one already.

Market Strategist Overview

Now that we have put shorter-term trends in perspective, we turn to what the consensus views are on the stock market’s recent rise. As of March 18, 2013 the year-to-date return for the S&P 500 Index was 9.35% (source: Morningstar). This is a high rate of return for a matter of months, and many of us would be happy to experience such gains over an entire year.

As you might expect, there are opinions on both sides, some pounding the table for continued gains, as well as those who think the market is doomed to swoon. A lot of research crosses my “desk” (really my computer or tablet these days). The following is a summary of the main viewpoints I have run across.

Reasons the Stock Market May Continue to Rise

  • Many strategists compare markets to each other, and as a result of extremely low yields available on bonds, they find the stock market relatively more attractive. There is some debate on how cheap the U.S. stock market is, so this may be more of a negative view on bonds than a positive one for stocks. Many do find non-US stock markets a reasonable value, however.
  • Corporate earnings in the most recent reporting season have materialized better than expectations held by Wall Street analysts. (When earnings are better than anticipated, we get what Wall Street calls the “earnings surprise” effect which lifts stocks prices.)
  • Economic news, while still not robust, has also been better than expected.
  • Many investors are still concerned about the markets and the direction of the economy. From a contrarian point of view, this makes the market more attractive. (Contrarians prefer that optimism not be rampant to maintain a positive view on a market.)
  • The recent Purchasing Managers Index for Europe showed continued economic contraction, but the southern periphery countries showed some improvement.
  • According to Ned Davis Research, markets which hit new highs have typically gone on to experience gains. While 2007 was a notable exception, the last dozen or so occasions when stocks first reached a new high, roughly 417 days passed before the market eventually peaked. The median gain during those runs was 18.4%.

Reasons the Stock Market Could Decline

  • The effects of the fiscal cliff have yet to be felt throughout the economy. Consumers have thus far reacted little to the fact that the payroll tax holiday has ended and that their pockets are lighter. But eventually they may pull back on spending, which has recently been funded by withdrawals from savings.
  • The U.S. sequester has yet to work its effects throughout the economy, although some note that this impacts a small percentage of GDP. So far, the markets have yet to react.
  • We still have very large macroeconomic risks which remain unresolved—U.S. fiscal policy and budget deficits, Europe’s debt woes (with Cyprus the most recent casualty), high unemployment, potential for China to slow down . . .  this list can get quite long.
  • Corporate earnings may have peaked, putting a different spin on recent strong earnings results. When coupled with domestic stock markets that are not clearly cheap, some strategists have lower expectations for further gains.
  • Interest rates have been rising lately in anticipation of the Federal Reserve pumping less money into the economy. This is a counterintuitive thought process—the economy finally improves enough that the Fed reduces stimulus measures, and the markets decline as a result.

Summary

As you can tell from the nearly equal number of arguments for and against continued market gains, in reality, there is no way to tell what the future market direction will be. Whether we are in a period of “subsidized optimism” (love that phrase from the Aden sisters, two technical analysts) or whether the market anticipates better times ahead, we cannot be sure.

But if you focus on the things you can control, and if you have a portfolio that is appropriate for the risks you are financially able to take, you have much better odds of meeting your goals regardless of market direction.

This discussion highlights the need for a plan for your portfolio as well as for your savings. If you have target weightings for different types of assets, then it is much clearer whether you should react, and if so, how. For example, if recent stock market gains mean that you have more stock exposure than your target percentage, you might consider taking some profits to get back to that target. If you are still trying to achieve a target weight in stocks, you might consider staging your investments over time in even amounts over a series or months or quarters. While studies show that a staged approach to investment doesn’t make a large difference in returns over a long time period, it can help us manage our reactions to market events and move us toward our goals.