Investors turn to stocks at the right time

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 S&P 500 climbed 29%, 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.

“The equity culture is not dead,” said Joseph Quinlan, the chief market strategist at Bank of America Corp.’s U.S. Trust, whose firm oversees $333 billion in client assets. “We kind of lost sight of the fact that equities still provide long-term good returns.”

The biggest rally since the 1990s is pulling annual gains back toward historical averages after the credit crisis wiped out $11 trillion in total U.S. market value. Everyone from Pacific Investment Management Co.’s Tony Crescenzi to MacroMarkets’ Robert Shiller observed in 2009 that investors were no richer then than they were a decade earlier.

Including reinvested dividends, stocks lost about 1% annually from 2000 through 2009, data compiled by Bloomberg show. Adding the most recent four years brings the return to about 3.5%, compared with the 6% 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% on an annual basis since March 2009.

“There are so many doom-gloomers that got this wrong,” said Michael Strauss, chief investment strategist and chief economist at Commonfund Group, whose firm oversees about $25 billion of assets. “The fact that there are still a lot of perma-bears pounding the table probably gives more potential of the market continuing to have days of upside surprises.”
EQUITY EUPHORIA

Near-unanimous buying has spurred concern that investors are too complacent. The Chicago Board Options Exchange Volatility Index, derived from the price of contracts used to protect against share declines, retreated 31% this year for its biggest decrease since 2009. The gauge averaged about 14.3, the lowest reading since 2006, data compiled by Bloomberg show. It closed below its historic mean of 20.20 on all but two days of the year, ending last week at 12.46.

“The equity market has been the one asset that stood out this year, the one asset that we haven’t seen volatility and we just see persistent increases without much of a decline,” said Arvin Soh, a portfolio manager with GAM. His firm manages more than $120 billion.

U.S. bonds fell 3.4% this year, poised for the first drop since 2009. For all the losses, demand for U.S. government debt remains stronger than at any time before the financial crisis as foreign central banks, insurers and pensions are willing to finance the largest debtor nation.

Investors bid for $5.75 trillion of notes in government auctions in 2013, or 2.87 times the amount sold, data compiled by Bloomberg show. The ratio is the fourth-highest since the Treasury Department began releasing the data in 1993, surpassed only in the past three years as demand peaked at 3.15 times in 2012. Before the Federal Reserve began its stimulus in 2008, the bid-to-cover ratio never exceeded 2.65 times in a year.
STOCK SWINGS

Stock swings will widen in 2014 as the Fed continues to cut its bond-buying program, according to Mr. Soh. The central bank will probably reduce its purchases by $10 billion in each of its next seven meetings before ending the program in December 2014, according to the median forecast in a Bloomberg survey of 41 economists.

“That makes things more challenging,” he said. “It means absolute returns that one would expect from the equity market will be lower than this year.”

Earnings growth is slowing. Profits rose about 3.8% per quarter this year on average, compared with 20% the three years before that. The slowdown pushed price-earnings ratios up about 20% to 17.4, an almost four-year high.

“2013 was a multiple expansion story,” said Rob Eschweiler, an investment specialist at JPMorgan Chase Private Bank, which manages about $935 billion. “Equities are approaching fair value range. They’re not historically expensive, but not historically cheap.”

The S&P 500’s gain this year created more stock market value in the U.S. than any year on record, according to data since 1990 compiled by Bloomberg. While the index advanced about 2 percentage points more in 1997, capitalization expanded by about $1.8 trillion less. The 34% rise in 1995 caused a $1.24 trillion increase in value.

Individuals are just starting to buy after watching the S&P 500 climb 172% to surpass the five-year advance that sent the index to a record in October 2007. Mutual funds that buy American equity took in about $21 billion in 2013, according to Investment Company Institutue data, while exchange-traded funds received $141 billion, Bloomberg data show. Bond funds had $67 billion taken out.

The preference for equities is a shift from the last four years, when about $260 billion was withdrawn from stocks and more than $1 trillion added to bonds.
“Markets have already moved, and markets lead investors,” said Sam Wardwell, an investment strategist at Pioneer Investments, whose firm manages about $225 billion. “We started the year with people scared to death that a lot of things could go wrong. At the end of year, the economy has really done very well.”

Profits for S&P 500 companies have climbed to more than $100 a share from about $60 in 2008. They’re forecast to increase 9.7% next year, almost twice the growth rate for 2013, according to analyst estimates compiled by Bloomberg. At the same time, revenue will pick up, climbing 3.8% in 2014, compared with 2.2% this year.

Gross domestic product will expand 2.6% next year, up from 1.7% in 2013, according to the median of 78 economists surveyed by Bloomberg. The unemployment rate fell to 7% in November, a five-year low, as weekly jobless claims held below 400,000 all year. The Fed cited the “improvement in the outlook for labor conditions” when it said Dec. 18 that it would cut stimulus by $10 billion next month. The S&P 500 set a new high that day.

“It’s a sign of recognition that things are on the upswing and the outlook is pretty good for this coming year,” said John Carey, a fund manager at Pioneer. “We can go back to thinking about corporate earnings and other things now that this to taper or not to taper debate is concluded.”

(Bloomberg News)