Either the current bond market is anticipating a rise in inflation, or bond investors are shunning the bond market for the stock market and may be making a mistake in doing so.
We think that is the case with tax-free municipal bonds: They still remain cheap. We do not own intermediate Treasury notes. They are not cheap.
Back to the U.S. stock market: On the heels of 2013, 2014 is unlikely to see such stellar gains. Stocks cannot go up 30 percent per year for years and years. It simply does not happen.
Stock market history shows that after surges similar to the one in 2013, the subsequent year usually has a positive result.
We expect that to be the case in 2014, and for several reasons: The economy will continue to recover at a measured pace; inflation will continue to be subdued; interest rates in the shorter- term maturities will remain very low; and bond interest rates will not immediately spike significantly higher than present levels.
The current 30-year Treasury bond yield is about 4 percent and the 10-year is about 3 percent; high-grade muni yield remains over 4 percent, while a money market fund still pays next to zero percent.
Bonds can hold at near-present levels during 2014, but they are not yielding enough to steal the show from the stock market.
Thus the mix could lead to a positive stock market return in the high single digits for 2014.
That would put a 2014 year-end close on the S&P 500 at 1950 or so. At the moment, such a result is possible. But there are risks, and the outlook could easily deteriorate.
Politics tops the risk list.
This year is an election year in the United States. The Republicans have a narrow majority in the House of Representatives, and the Democrats have a narrowing majority in the U.S. Senate.
As a country, we have a dysfunctional and divided government.
Both houses of Congress are in for a massive fight. Incumbents face primary threats from the extremes of their respective parties. Neither party nor chamber wants to be blamed for something going wrong. Each seeks power while being risk-averse when it comes to blame.
Despite the sharp divisions, since blame avoidance is now the word in Washington, political risk in the U.S. due to some policy impasse has apparently eased. But that also means the penalty for failure is very high.
Markets seem to be pricing in a docile political environment, one unperturbed by a government shutdown, a debt-ceiling fight or an external shock from some geopolitical event—North Korea? Iran?—or some other politically induced catastrophe.
Such an assumption of sustained calm and stability sometimes flies in the face of history.
The world is still a dangerous place. Washington, D.C., is still a dangerous city from the perspective of the rest of us Americans, who have to put up with the shenanigans of the people we elect to govern us. Risk in the political arena, I’ll repeat, remains high in 2014.
Looking back, we just had a terrific year. As of Jan. 1, 2014, we remain nearly fully invested in our U.S. ETF-managed portfolios.
But we must look forward with caution and navigate the year’s opportunities with a close eye on winds, weather and the seaworthiness of our investment strategy.
Cumberland Advisors is a registered investment advisor based in Sarasota, Fla. Founded in 1973, the firm has clients all around the U.S. and several foreign countries. It manages about $2.2 billion of fixed income and runs separately managed equity accounts built solely of ETFs. Contact Cumberland at 800-257-7013 or at www.cumber.com/.