January 2014

What Happens Next?

The 113th Congress so far is the least productive in history. Paralyzed by gridlock, Congress sent a record low number of bills to the president for his signature and instead spent endless amounts of time on pointless debates; for example, the House more than 40 times voted to dismantle the Affordable Care Act, although such a move was doomed in the Senate.

While pundits can discuss whether this historic inactivity was good or bad for the nation at large, it apparently was good for the financial markets -- to the surprise of many, including us, who worried that the government shutdown last fall would linger and damage the recovery. But apparently by doing so little overall, Washington did little to upset the markets. As a result, the markets focused mainly on economic realities such as a recovery that saw continued low interest rates, rising consumer confidence, increasing employment and growth in the GDP.

Perhaps most significantly, markets focused on earnings. At the beginning of 2013, the S&P 500 was trading at about 13 times expected earnings, which made stocks a bargain overall. Investors acted on that, driving the S&P up more than 25% for the year.

But at the end of 2013, S&P stocks were trading at about 17 times earnings -- which is much closer to fair value. So the question becomes: What happens to the markets in 2014?

It is possible, of course, that the GDP and corporate profits will continue to rise and, since markets react to profits and the expectation of profits, that will trigger another year of exceptional performance. But stocks are not dirt cheap any longer, so it is also possible that market performance will be much closer to the historical averages or even that there will be a significant correction.

Of course, no one can predict the future. If you check the Internet, you will find about an even split between folks who think the big increases will continue and those who think we are in for a crash. But as we move into 2014, there are some things to remember.

First, there is no indication that Congress will be any more productive this year than last, especially with mid-term elections looming. That probably means that, barring some kind of unforeseen event somewhere in the world, markets once again will be driven mainly by economic factors. And, for the most part, pure economic factors are more rational and fact-based than other factors to which the market often reacts, such as geopolitical events.

However, since the markets are currently trading at a level that is supported by earnings, the choice of individual stocks will become extremely important. When the markets overall are rebounding strongly, that rebound tends to be distributed over a wide range of stocks. But when market growth is slower, choosing stocks with the best fundamentals historically has resulted in the best chance of success.

In addition, dividends become even more important. Companies are sitting on a record $1.25 trillion in cash, and aggregate dividends hit a new high in 2013. Since 1929, reinvested dividends have represented about 50% of total returns, making them a significant contributor to portfolios.

At Peachtree Investment Partners, our philosophy always has been to focus on well-run, competitive companies with good cash flow and a strong history of paying dividends. We believe that this offers the best chance of success in good markets and in bad. Strong companies are best positioned to benefit from market opportunities and to react to economic setbacks. And dividends provide both additional growth and some protection from volatility.

We intend to continue this approach in 2014, whatever the year brings. And we would like to wish you and yours a happy, healthy and prosperous new year!

Garry K. Schaefer
Atlanta, Georgia
January 8, 2014

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