Q4 AND 2013 IN REVIEW

Condor Asset Management is celebrating our fourth anniversary. We have consistently matched or outperformed comparable stock indices. Over the last year we also achieved stock returns in excess of 30% while maintaining our commitment to solid conservative investment profiles, as per the request of the majority of our clients. We are proud of our track record and appreciate the trust our clients have placed in us.

Over the last 3 months North American equity markets continued their winning ways. The S&P/TSX index gained 6.5% and the S&P 500 increased 9.9%. The full year was even better with the S&P /TSX gaining 9.4% and the S&P 500 increasing 29.6%. When factoring in the movement of the US Dollar relative to the Canadian Dollar, the US market provided Canadian investors with a gain of 38.9%. Contrary to some predictions, US Dollar strength relative to most major currencies persisted throughout 2013. We see few near term reasons why the Canadian Dollar will recoup these losses (vs. the US $). See our next blog entry.

Positive economic data is a catalyst for the upward movement of the stock market. The final revision to third quarter US GDP growth was +4.1%, partially boosted by an inventory build. Businesses typically build inventory when perceptions regarding the economy are positive. The employment data also highlighted a growing economy. Jobless claims dipped below 300,000 while November non-farm payrolls increased by 202,000. The unemployment rate declined to 7%, which is The Fed’s originally stated target for reducing the quantitative easing program. One of the bright spots was auto sales hitting levels which have not been seen since the financial crisis of 2008. Another highlight was the ISM (Institute of Supply Management) survey which yielded positive results of greater than 50% (which signify expanding demand). The ISM manufacturing survey was 57.0% while the comparable data for services was 53.9%.

This abundance of positive economic data has resulted in rising interest rates. Investor anticipation of a taper announcement pushed US bond rates to 3%. At the conclusion of The Fed's Open Market Committee meeting in December, The Fed announced that they would reduce bond purchases by $10 Billion a month starting in January. They further stated that depending on the data, they would continue reducing purchases throughout 2014.

Canadian bond returns during the past year were -1.2%. This is only the third year of negative bond returns since 1979. Bond returns over the last two years were a miniscule +1.2%. With current rates being as low as they are, rate increases will likely result in bond returns similar to the last two years. We currently prefer short term bonds so our clients are positioned to take advantage of potential reinvestment opportunities presented by higher interest rates.

We do not subscribe to the theory that rising interest rates will be negative for stock markets. An increasing interest rate environment accompanied by a growing economy is typically positive for stock markets. These conditions are currently present in the US and to a lesser degree in Canada. The US economy is forecasted to grow 2.5% - 3.0% in 2014, with Canada facing more modest growth of 2.0% - 2.5%. Both growth forecasts are an acceleration from the 2013 GDP growth rates. The US stock market surged with the Feds announcement of its reduced bond purchases. The Fed also surprised the market by promising to keep interest rates at current low levels for "an extended period of time". While this appears to be positive in the short term for financial markets, an accelerating US economy will probably make this a short lived promise.

There has been a fair amount of discussion concerning the potential of a stock market crash. We believe this is unlikely to occur. The crash argument hinges on the stock market being in an asset bubble created by low interest rates. It is extremely rare that so many pundits correctly call a bubble in a timely manner. When looking at the fundamentals compared to prior bull markets, stocks are not overvalued. Stocks on average trade at 15 times earnings, which is close to the historical average (Chart 1). Stocks are neither historically expensive nor cheap. With 8% earnings growth forecasted for 2014 (and 2015), there is still upside embedded in individual stocks.

Chart 1: S&P Trailing P/E

Source: Deatsche Bank

We did see a minor stock market correction (around 5%) near the end of September. We expect there will be at least one, if not more, corrections in 2014. This does not change our belief that equity markets offer reasonable returns for the foreseeable future.

Our discussion up to this point has been predicated on a reasonable US GDP growth rate. To date, growth has been somewhat tepid. Having said that, all the variables are in place so that 2014 might be the year where growth accelerates above 3%. Contributors to this would be improved employment rates, a better than expected housing recovery, growth in auto sales and the wealth effect.

2013 US GDP growth was depressed by approximately 2% in part due to higher taxes and reduced government spending. This follows two years of fiscal spending dragging down growth by about 1% per year (light blue line in Chart 2). US Government spending has been declining since 2009, while private sector GDP has grown at a 3.3% pace during the same period. Most of this fiscal spending handicap will disappear in 2014. State and local governments are beginning to invest in long delayed infrastructure projects. The Federal government recently passed a two year budget with less severe spending cuts than originally planned. The budget deal also reduces uncertainty by lowering the risk of a government shutdown due to legislative dysfunction. This is positive for the stock market, as investors dislike uncertainty and try to avoid. With government spending not impeding GDP growth, the US economy has potential to grow at something closer to 3.5% in 2014.

Chart 2: Real GDP

Source: BEA, Haver, Deatsche Bank

The wealth effect may also lend some support to accelerating growth in 2014. The consumer has been deleveraging (by increasing their savings rate) over the last few years in order to reduce debt levels. This growth impediment was necessary to repair the damage from the financial crisis. Consumer’s financial balance sheets have significantly improved. Less consumer debt combined with low interest rates have resulted in the household debt servicing ratio (Chart 3) currently being at the lowest level in 30 years. The lower income necessary to service household debt suggests that consumers will have more money available to spend.

Chart 3: Debt Service Ratio

Source: The Federal Reserve, J.P. Morgan

Bull markets typically do not end unless there is a recession. Based on the abundance of positive economic indicators, a recession is not in our near term forecasts. If anything, we see an economy that is slowly gaining momentum. The biggest surprise for 2014 could be an economy that returns to normal. We define a normal economy as one that has a healthy employment market, buoyant housing and auto sectors and no fiscal drag from government spending. This would increase the probability the economy would grow in excess of 3%, which is has not done since before the recession.

Stocks are currently more attractive than bonds. While bonds are an important part of a diversified portfolio, their returns will be below historical levels. We see positive returns for both the US and Canadian stock markets but not to the same degree as 2013. Going forward, stock selection and being in the right sectors will be an increasingly important part of generating above average returns. Condor Asset Management has demonstrated that we can navigate the market risks and provide superior returns. Please contact us at Condor to see how we can aid you in designing a portfolio to help you achieve your financial goals.