I am always reticent about giving my market opinion given that my firm specializes in not making market predictions. Instead, we focus on long-term objectives that have the highest probability of out-performing the market on a risk-adjusted and absolute basis.
We believe that market timing and stock selection is difficult, if not impossible, and that asset allocation is limited in its ability to manage risk and protect against large market declines. For that reason, our focus is to manage the risk by hedging it with insurance. Most people are unaware it is even possible to purchase insurance on investments just like they do on their life, autos, house and health.
Quite frankly, it is impossible to know how future events are going to play out, but I believe it is quite possible to put the current situation in context and prepare for whatever ultimately happens.
That being said, my prediction for 2014 is a flat to declining market with an increase in market volatility. My reasons are as follows:
1. The bull market is long in the tooth since the lows in March of 2009.
The bull market is almost 5 years old, which is longer than the historical average. The last two bull markets lasted … you guessed it, five years. Research from Strategic Capital Allocation’s Brian Hunter reflects that every decade since 1900 has experienced one to three severe bear markets that average an approximate 35 percent decline. We have not had even one sell-off in this decade.
2. Several indicators are flashing warning or outright sell signs.
For example, the bullish sentiment is at or near all-time highs. The VIX, a gauge of fear representing the average implied volatility of the front month S&P 500 options, has until recently been at a seven-year low. Dividend yields, cash levels in mutual funds and price-to-earnings ratios are historically high. This is not to say they cannot continue at these levels, but the odds for substantial market increases over the next 10-year period are rather small.
3. The Federal Reserve cannot continue its accommodative policy of indefinite easing and may even eventually lose control of the monetary policy.
The market currently believes the Fed can pull off the great asset reflation by driving down and keeping interest rates low so that the TINA trade (there is no alternative) is to buy stocks. Surprises must be to the downside. Even if the Fed does not lose control, it will likely be forced to remove or lessen its policy on its own. Very few believe that recent market advances are not materially affected by the Fed policy, and Fed policy is likely creating an equity bubble that will eventually burst. It is also very likely the Fed pullback will dramatically and negatively affect the fixed-income markets as interest rates rise, creating a double dose hit of losses as fixed income and equities fall in tandem providing very little shelter for most portfolios.
4. The structural problems in this country have not been fixed and quite frankly are not even being discussed.
There is a lot of talk about Obamacare and the effects on the economy, but there are no real solutions to the long-term structural problems in this country for Social Security, Medicare and Medicaid that do not involve significant pain. I believe there is going to be pain and lots of it, which is why the split government in Washington has decided to ignore the problem. The current path of fiscal responsibility, or actually irresponsibility, should have long-term negative effects on the stock market. The timing, however, for this decline is unclear. The simple reason is that required cuts to entitlement and pensions will have a drastic effect on aggregate demand and gross domestic product.
5. Natural Law: The laws of nature demand a day of reckoning.
For example, labor participation is at an all-time low, but few would argue that the Federal Reserve’s intervention was more than a delaying tactic in the hope of outgrowing these problems. Interestingly enough, most of the problems can arguably be attributed to government intervention in the first place (i.e. housing bubble). Question: Do we believe that there are consequences to our actions? If we can escape problems that we created without any pain, the answer must be no. Very few believe this to be true. If I eat too much, then I will gain weight, and likewise, if we spend too much as a society, we will eventually have to cut back and pay off the accumulated debt. Short of a default, there is no other way to fix the structural problems other than cut spending and pay back debt. Cutting spending and paying off our debt, as anyone learns, is quite painful. The end result on our economy will be shrinking demand and therefore market decline.
In conclusion, I have listed several reasons why I believe the market will decline in 2014. Admittedly, some of these problems could take years or decades to play out. In any event, investors should not make critical investment decisions based upon short-term conditions (e.g., one year such as 2013), but rather over a typical full market cycle such as five to 10 years. Simple probabilities and the points made above indicate it very unlikely that we are in a sustained bull market and that all is rosy in the world. Oliver Wendell Holmes once said, “Prophesy as much as you want, but always hedge.” This is especially significant with the market’s current level of risk. What are you doing about it?
Randy Swan is the owner of Durango-based Swan Wealth Advisors, Inc., a SEC Registered Investment Advisor and the source of the proprietary Swan Defined Risk Strategy. This information is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, product or service.
