Jan 17 2014, 11:45am CST | by Forbes
This year’s stock market was like Christmas at the in-laws. You didn’t really want to be there, but the consequences of staying away were even worse. Still, in the end, you were glad you participated. In fact, really glad.
The S&P 500 gained 32.4% in 2013. Small-cap growth stocks, as measured by the Russell 2000 Growth Index, posted a 43.3% gain, and the Oberweis Report Model Portfolio returned about 68% for the year. By all accounts, it was a stunningly good year for equity investors and the best since 1995.
Our cheery outlook letter last year materialized. Our bottom line forecast in January 2013: “It could be a very Happy New Year.” Despite geopolitical uncertainties and political gridlock, we were still enthusiastic on the market due to cheap prices: “We believe…that below-average valuations—the S&P 500 Index’s trailing P/E is currently 13.7x compared to a 50-year average of 16.5x—reflect much of this lingering uncertainty and expectations for lackluster economic growth.”
That was on the mark—uncertainty declined, risk aversion subsided, and the S&P 500 P/E ratio reverted back to mean levels for the first time since the financial crisis. As we predicted, interest rates rose and gold fell as investors shunned risk-averse behavior common over the last few years and plunged back into stocks. Gold fell 28% in 2013 while the 30-year Treasury yield rose from 2.95% to 3.96%. Risk aversion abated even without political harmony or debt reform.
In last year’s letter, we also predicted China would do well in 2013. Our score on that one depends on how you measure it. Broadly, China underperformed many regions, as the MSCI China Index posted a meager low-single-digit return. However, our Oberweis China strategy performed extremely well, gaining over 57% for the year, due to successful investments in high growth companies in e-commerce, smartphones, health care and clean energy.
Despite our naturally positive attitude, the reasons to remain bullish in 2014 are gradually slipping away, at least from a fundamental perspective. Our favorable call for equities in 2013 stemmed from below-average valuations and above-average investor skepticism. Today, valuations are at more normal levels and skepticism is less pervasive, although the euphoria typical at market tops is not yet present.
These days, the S&P 500 trades at P/E of 17.4x (or slightly higher than its 50-year average of 16.5x). Likewise, investor risk aversion has dropped markedly, as evidenced by investors dumping bonds in favor of stocks and real estate during the second half of 2013. Specifically, from June 30, 2013 through December 18, 2013, bond funds experienced $170 billion in out flows while equity funds had $80 billion in inflows.
Interestingly, of that $80 billion in equity inflows, 90% went to funds that primarily invest in non-U.S. equities (according to the ICI), implying that a fair amount of skepticism regarding the U.S. economy and the U.S. market remains.
If P/E’s are back to a normal range and confidence in the market has returned, the economy must be booming, right? Hardly. Unemployment remains at 7.0% and we estimate GDP growth of only 3.0% for 2014. The economy is doing better, but booming would be a dramatic overstatement. Many of the same macroeconomic risks that plagued equities in the past linger. Geopolitical gamesmanship continues with our friends in Iran, North Korea and—to a lesser extent—Russia.
Congress still hasn’t pulled its head out of its caboose in dealing with the deficit, even though it finally reached a budget agreement late in the year. In many states, pension costs continue to weigh on weary taxpayers, with myown home state of Illinois ranking as the poster child of fiscal irresponsibility. (Incidentally, Jim Oberweis Sr. is now a sitting Illinois State Senator trying to fix this mess and is concurrently running for U.S. Senate).
Additionally, the end of the Fed’s quantitative easing program threatens to put further upward pressure on interest rates.
Still, fundamentals are only a piece of the full picture. In the near term, the spigot of money flows into equities—particularly international equities—is clearly on in full force and possibly accelerating. During the period January 2007 to June 2013, bond funds experienced inflows of $1.1 trillion!
Though the trend reversed in the second half of 2013, only $80 billion has flowed back into equities and only 15% of the massive bond fund inflows since 2007 has departed. That is to say: the equity inflow trend isn’t over yet. Momentum is clearly on the side of the stock bulls, and momentum alone will drive equities higher in 2014, irrespective of the fundamentals.
To sum it up, we’re still constructive on equities, but less so than in recent years. Although we aren’t sleeping quite as soundly at night these days, equities will deliver more positive returns in 2014, but the percentage gain will be more modest than in 2013, likely in the single digits or low teens.
Based on fund flows, expect international equities to outperform in 2014, especially in the beginning of the year. Interest rates will continue to rise, and we expect another 50 – 100 basis point increase on the 30-year Treasury yield to 4.45-4.95%.
Gold, after being bashed to pieces in 2013, will stabilize around $1,150 – $1,250 per ounce, but appreciation will be capped by rising rates and decent returns in stocks. Still, with valuations back to normal, the risk of unanticipated macroeconomic events disturbing the peace has risen markedly. It’s one thing to buy stocks when the economy is bad and the end of the world is expected. It’s quite another to jump in when investors anticipate smooth sailing and equities have been priced accordingly.
In short, follow the money but do so with caution. Sidelined money will return to equities and pump up prices even more in 2014. Still, with valuations at their highest levels since the financial crisis, be aware that the risk of adverse surprises is certainly on the rise.
One stock I currently favor is Montage Technology Group, a global fabless provider of analog and mixed-signal semiconductor solutions currently addressing the home entertainment and cloud computing markets.
In the home entertainment market, the company’s technology platform enables the design of highly integrated solutions with customized software and support for set-top boxes. In the cloud computing market, Montage offers high performance, low power memory interface solutions that enable memory-intensive server applications.
Since its inception in 2004, Montage has sold more than 230 million integrated circuits that have been shipped to more than 150 end customers worldwide. Initially, Montage developed commercial solutions for the home entertainment market to address the rapidly growing demand for television in China, Southeast Asia and other emerging markets.
According to iSuppli, the total number of set-top boxes sold by Chinese manufacturers is expected to grow at a compound annual growth rate of 12% from 2012 to 2016. Montage’s end customers in the home entertainment market include nine of the 10 largest set-top box manufacturers in China as measured by units sold in 2012.
In the cloud computing market, Montage is currently one of two LRDIMM memory buffer suppliers validated by Intel for DDR3 technology, the most prevalent industry standard for memory integrated circuits used in servers. Montage expects revenue from LRDIMM memory buffers to increase as a percentage of total revenue, driven largely by growth in cloud computing.
In its latest reported third quarter, sales increased approximately 46% to $30.1 million from $20.6 million in the third quarter of last year. MONT reported earnings per share of $.30 in the latest reported third quarter versus $.23 in the same quarter of last year. Clients of Oberweis Asset Management own approximately 25,000 shares. These shares may be appropriate for risk oriented investors.
Excerpted from January issue of The Oberweis Report.
Source: Forbes Business
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