Last year was a year for the record books.
Investors were bolstered by a growing sense of confidence that overwhelmed the negative developments that should have kept the equity markets on the defensive. Throwing caution to the wind, they looked at every downturn as an opportunity to add risk by dumping bonds and buying stocks.
Investors had entered the year with low earnings expectation. Concerns that Congress would take the US economy over the “fiscal cliff”, as well as the continuing malaise in the euro zone, led most market observers to expect gains only in the range of 5%. But as one famous market observer said three decades ago, no one has ever been able to successfully predict the timing of major market swings – either up or down.
By year end, the Standard & Poor’s 500 index, a widely used proxy of the overall market, gained 29.5%, and when dividends are included, it soared 32.5%. That was its best annual gain for that index since 1997. The narrow, and largely irrelevant, Dow Jones Industrial Average also jumped 27% - its best year since 1995.
The Nasdaq Composite Index registered an even larger gain: 38% - its best annual gain since 2009. Small-cap stocks, as measured by Russell 2000 index, soared 37%. That was their best performance since 2003.
Fixed income securities, on the other hand, remained under pressure.
The yield on the US 10-year note increased to 3.03% at year-end, up from 1.76% at the beginning of the year. Investment grade bonds, as measured by the Barclays U.S. Government Long Index, declined 12.5%. That was only the third decline in the past 34 years and second in size to the losses suffered in 1999.
Mortgage-backed Securities index and municipal bonds index declined 2% and corporate long term bonds index dropped 6% and TIPS index, the measure of inflation linked U.S. bonds, plunged 9.3%. But, high yield bonds index gained 7.5%.
Investors shifted assets from bond to stock funds.
Investors pulled $75 billion from bond mutual funds in 2013, the first withdrawal in a decade and it surpassed the previous record withdrawal of $63 billion in 1994. But at the same time, they added $350 billion to stock-based mutual funds and exchange traded funds.
That was the largest ever annual inflow and after years of withdrawals.
The only thing that kept interest rates from climbing further was underlying support by the Federal Reserve. They continued with their third round of quantitative easing, buying US Treasury paper and mortgage-backed securities at the rate of $85 billion a year. That action not only reduced the amount of fixed income paper in the market, but also added reserves to the banking system and kept downward pressure on short rates.
The positive sentiment toward US equities built on itself as the year progressed.
The S&P 500 index registered 45 new highs during the course of year, while the Dow Jones industrial average registered 52, including the final trading day of the year.
Stocks in consumer cyclical, financial services, industrial and healthcare sectors surged nearly 43% but utilities gained 14% and real estate liked companies or REITs gained paltry 1.8%.
The steady rise in the market also supported a spike in initial public offering and 222 companies raised nearly $55 billion through initial public offerings, the strongest investor interest since 2007 when 279 companies raised $65 billion.
Net earnings for the S&P 500 companies increased only 6.5% for the year, which implies that nearly 80% of the market advance was the result of improved price-to-earnings multiples. For the S&P 500, the trailing earnings multiple increased to 18, up from 14 at the beginning of the year.
Historically, the S&P 500 index has had an annual return of more than 20% only five times since the modern version of the index was launched in 1957, including this year.
Earnings for the companies exceeded $100 for the first time and dividend rose to $36. In addition, the number of companies in the index paying a dividend increased to 417 - a 17-year high. Of those companies, 329 chose to increase their dividend averaging a payout ratio of nearly 32%.
Of the top 10 best performing stocks in the S&P 500 index, nine were “out of favor” stocks during the past few years, including Netflix, Best Buy, and Micron Technology. Netflix had soared to $295 in July 2011, plunged to $54 in July 2012, before soaring 295% in 2013. That brought its price to 94 times projected earnings. Best Buy surged 242% on the prospect of its restructuring plan after the stock plunged at the end of 2012.
Hewlett Packard, Yahoo, Western Digital also doubled, while Priceline soared 87%. After struggling with the loss of investor confidence following the largest technology related public offering ever, the price of Facebook Inc doubled in price and regained investors favor after its earnings met expectations.