Portfolio Manager & Chief Investment OfficerArticle By Joshua E. BetancourtPortfolio Manager/Financial Planner

4th Quarter Results

Stocks produced excellent returns in the 4th Quarter of 2013, bringing the S&P index to new record highs. The S&P 500 Index had its best year since 1997 and all 10 S&P 500 sectors recorded positive returns, with only the the defensive telecommunication services and utilities segments trailing significantly. Small and mid-cap stocks lost a bit of ground to large-caps for the quarter but ended with respectable gains for the year. Growth stocks were in vogue for most of the year as the cost of capital was well below normal given the historically low interest rates. In low interest rate environments, Growth sectors typically outperform Value sectors. This will likely change in 2014 as interest rates have already begun trending higher.

As forecasted in prior newsletters, US Treasuries and Investment Grade Corporate Bond’s total returns were below prior year averages.  Many bonds sectors yielded negative returns. Due to their greater sensitivity to changes in interest rates, investment-grade corporates, municipal bonds and treasuries were hurt by the increase in interest rates. Throughout 2012 and 2013, QCI under-weighted these sectors, opting for High Yield Bonds and a larger than average weighting towards stocks. Because of their larger credit spread over treasuries as well as their lower duration characteristics, High Yield Bonds were not affected by the rising interest rates and QCI’s High Yield Bond allocation produced the best total return within the fixed income universe.

QCI’s fixed income allocation continues to be in high yield, short duration bond ETFs: SJNK and JNK. Our high yield bonds were shielded from the spike in interest rates and have allowed us to collect a annualized yield of 6% (SJNK) & 7% (JNK) respectively. Given the huge sell-off in REITS and mortgage-backed securities, we look to diversify our portfolio with these sectors.  We expect that the increase in interest rates will continue, albeit at a slower pace, potentially having less of a negative impact on total return.

2014 Year-End S&P Forecast

While the returns of the S&P in 2013 were impressive, we must point out that the majority of market appreciation came from P/E expansion, and less from overall earnings increase. To better understand P/E expansion, let us define the term.

A price-to-earnings (P/E) ratio is the current stock price divided by annual earnings per share (EPS). All three components in the equation: stock price, earnings per share and resultant P/E are constantly changing. A change in one component causes changes in the other two. A price-to-earnings (P/E) ratio is a current stock price divided by annual earnings per share (EPS). All three components in the equation — stock price, earnings per share and resultant P/E — are constantly changing. A change in one component causes changes in the other two.

A P/E shows how much investors are willing to pay for a dollar of earnings. The higher the EPS growth rate, the more investors are willing to pay for a stock and the higher its P/E can get. For example, XYZ stock, with an EPS growth rate of 10 percent, may have a P/E of only 8 because investors see poor growth prospects; ABC stock, with an EPS growth rate of 30 percent, may have a P/E of 40, or even 60. A stock price and its P/E, will generally expand or contract in proportion to EPS growth changes.

Although different stocks and stock groups have different P/Es based on their respective growth rates and prospects, P/Es are not permanent and can expand or contract with the economic cycle, market conditions or investor outlook. In other words, how much investors are willing to pay for the same dollar of earnings in a stock varies over time. For example, ABC stock, with an EPS growth rate of 30, may command a P/E of 30, 40, 50 and 60 as the stock advances in a strong market, and decline to 50, 40, 30 and even 20 in a weak one, without much change in the EPS growth rate.

S&P Price to earnings ratio, based on trailing twelve month “as reported”earnings.

As you can see from the chart above, in 2013, 75% of the S&P return came from the overall PE expanding to 19.56x from 13.7x trailing 12 months reported EPS. Had the market appreciation come strictly from earnings growth, there would not have been such a dramatic increase in the P/E multiple. While stock indexes like the S&P 500 have hit all-time highs, we believe the P/E is still not valued at the levels that have marked the end of bull markets in the past. However, for sustained market upside potential, the market driver for the S&P will have to come more from actual earnings growth rather than P/E expansion.The good news is that global growth is back on track and global growth outlook has been recently upgraded by the World Bank. Growth fuels earnings and if correct should provide some support in the face of P/E contraction.

Using the historical S&P Mean average P/E of 15.5 and projected 2015 EPS of $133.80 gives us a fair value target of 2073 for the S&P 500 as year-end 2014 fair value. Based on the current 1838 level of the S&P 500, this represents a potentially respectable return of 12.83%, due to earnings growth. I won’t rule out further PE expansion but any further increase in interest rates historically reduces the likelihood of P/E expansion. Clearly any changes is growth rates and global market conditions will have an effect of S&P earnings estimates and targets will change. However, by using historical benchmark P/E ratios and valuations one is likelier to get close to fair value rather than simply investing blindfolded. In 2013, QCI weighted its portfolio more towards equities and less towards bonds with a 75/25 average stock to bond allocation in our most aggressive portfolios. Given the market backdrop regarding interest rates and growth projections, we believe 2014 should provide the best opportunities for a diversified portfolio consisting of High Yield bonds, CMBS’s, Cumulative Prefferreds, select MLPs, REITS, and overweight Value equities both domestic and foreign. Given this outlook, we believe the ideal target portfolio allocations in 2014 should come back in line to a 50/50 stock to bond allocation. If you have any questions regarding our 2014 outlook or would like to speak to anyone of our Financial Advisors regarding a personalized financial investment plan feel free to contact us at 1-800-895-4918.