2013-A Great Year in the Market

Last year (2013), the Dow Jones Industrial Average rose 32.4%. Sounds like a phenomenal increase, doesn’t it. A plus 32% increase is, indeed, an impressive increase. However, in this case, a little more analysis is warranted. Why did the market increase so much? The following data are from Standard & Poor’s and J.P. Morgan Asset Management Guide to the Markets-US (as of 12/31/2013).

Price/Earnings Multiple Expansion

 

Of the 32.4% increase, 18.4% (or 57% of the total increase) was due to an expansion in the price/earnings multiple. Investors buy stock in anticipation of a future earnings stream from the issuing company. The price to earnings ratio represents “how many times” the company’s earnings that investors are willing to pay for the stock. In 2013, that price/earnings multiple expanded from approximately 14 times to over 16 times. Quantitative Easing (the Fed’s buying of Treasuries and mortgage backed securities) figures prominently in this increase; the Fed’s buying drove interest rates so low that stock became a more viable investment (even with the increased risk).

 

Dividend Increase

 

Dividends accounted for 2.8% of the 32.4% gain (9% of the total increase).

 

Earnings

 

Corporate earnings accounted for 11.2% (or 34%) of the total 32.4% increase in 2013. What about those earnings? How were they obtained? In many cases, earnings were driven by expense reduction, not increased revenues. A company can do only a finite amount of expense reduction and still remain in business.

 

What Does This Mean?

 

Given the above, how likely are we to continue such growth? Ninety one percent of the gain was driven by factors that may not be in play going forward.  At Paragon Financial Advisors we believe that the equity markets offer significant long term benefits; however, the ride from “here to there” can be bumpy. Come visit with us about ways to try to manage the risk in reaching your long term financial goals.   Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

               

Investment Diversification

One of the basic axioms of investing is portfolio diversification. Simply put, an investor should not “put all eggs in one basket.” Prudent investing includes allocating your investment dollars among asset classes (stocks, bonds, cash, etc.) and different investment styles (large cap value, small cap growth, international, etc.). That allocation should be done in accordance with the investor’s goals and objectives; generally the higher the allocation to stocks, the greater risk in the portfolio. One of the factors that may not be considered is the investor’s job or employment. What do we mean?

First, one of the greatest destroyers of wealth is the necessity to liquidate investments in a down market to meet necessary living expenses. Therefore, anyone in a tenuous job situation should ensure an adequate cash/fixed income reserve to cover living expenses in the event of job loss. This reserve may mean a lower exposure to stocks. A corollary to this job situation is the entrepreneur or small business owner who may face significant new challenges in view of tax changes and health care requirements under the Affordable Health Care Act. Risk in the business environment might indicate more stable fixed income investments in the investment portfolio would be advisable.

Second, and a more likely scenario, is a concentration of investments and employment. Does an employee have most (all?) of their 401(k) investments in company stock? Some dangers exemplified here are wealth tied to the company (think Enron) or industry. Frequently investors will have investments associated with their profession/industry—perfectly logical given their understanding of the industry. However, such concentrations can pose special risks. A downturn in the industry can potentially affect both employment and ancillary investments. The downturn in the housing industry resulted in declines in home building employment and associated businesses that supplied the industry.

At Paragon Financial Advisors, we try to assist our clients in doing a through risk analysis. That risk analysis includes two components: 1) the investor’s risk tolerance, and 2) risk exposure to things of which the investor may not be aware such as the situations discussed above. Please give us a call if we can assist you.   Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.