If you have not been living under a rock for the past year, you are probably aware that the stock market has been on quite a tear of late! For 2013, the broad stock market, as measured by the S&P 500 Index, ended up almost 30% for the year and closed the year at an all time record high. The more popular Dow Jones Industrial Average (DJIA) also closed the year up 26.5% at its all time high.

So what led to this skyrocketing market? As it turns out, there are two basic components that go into the calculation of the value of an index. One is the amount of net income the companies in the index earn for the year. The second is how much investors are willing to pay for those earnings. For example, if the total net income from all of the companies in the index totaled $100 and investors were willing to pay 10 times those earnings, the index would be $1,000 at that point.

With this information, we can look at both of these components to see what drove the gains for the year. Earnings grew 4.93% year-over-year through September. However, if we look at analysts expectations for the full year, earnings are expected to be 11.8% ahead of last December. If we assume that companies really do end the year with a bang and report earnings that are pretty close to what analysts expect, then about 12% of the market gains were due to companies making more money, which is a good thing. This is more proof that our economy really is getting better, albeit grudgingly. But where did the rest of the gains come from?

Well, at the end of 2012, investors were willing to pay about 16.5 times the total earnings of all of the companies in the index. As of the end of 2013, investors were willing to pay about 19 times the expected earnings for the entire year through December (assuming analyst estimates are pretty close). The Price-to-Earnings ratio (PE ratio), which is what this measure is called, grew 15.5% for the year. Investors were “bidding up” what they were willing to pay for stocks. This is an indication that investors were taking on more risk throughout the year. In other words, even as earnings were growing for companies in the index, investors were paying higher premiums to purchase this stream of earnings. It was almost as if investors were chasing stocks as the only place to invest – which they were, in large part.

So, with investors taking more risk with stocks, it was hard not to do reasonably well this past year. Just about all stocks gained ground. We had quite a number of successes in client accounts such as Navios Maritime (NMM), which ended the year about 35% higher than where we purchased it, and TESSCO Technologies (TESS) which gained 82% for the year. Among the new names we added in the fourth quarter were John B. Sanfilippo & Son (JBSS), which processes and sells nuts primarily under the Fisher brand name, and a convertible preferred stock from National Health Care (NHC). This last holding is a class of stock that is convertible into shares of the common stock at about $65 per share. The common stock is currently selling for about $53 per share, so for now, we are happy to collect the dividend. Currently, the shares pay a healthy 5.35% dividend based on our average purchase price. If, as we suspect, the company continues to do well – it runs 130 assisted living and retirement homes around the nation, so it should be a big beneficiary of an aging population – then as the common stock continues to climb in value, eventually our share values will climb as well.

The inevitable question is what can we expect for this year? Are the gains of 2013 sustainable? With the economy continuing to get better, companies are likely to continue their earnings growth. Analysts expect the companies in the S&P 500 Index to grow their earnings by about 9.6% this year. We think that may be a bit too optimistic, but we do expect continued earnings growth. The bigger question, though, is what investors will be willing to pay for those earnings. If investors maintain their same tolerance for risk, we could see stock gains in line with the 10% growth in earnings. If investors increase their appetite for risk – that is, if they pay more for that stream of earnings than they currently are paying, we could see another 20% – 30% gain. However, that would approach bubble territory for stock prices and that would really cause us to cut back on our equity exposure. If investors become more cautious, we could see the index actually fall a bit. For example, if earnings do increase as analysts expect, but investors become more cautious and only offer to pay the 16.5 times earnings they were paying at the start of 2013, the index would actually fall about 5% for the year. If earnings fall short of expectations, this would lead to a larger pullback.

The bottom line is that we enter 2014 cautiously optimistic. While we have been talking in broad generalities about stock indexes, keep in mind that we are not buying the indexes. We are buying individual securities. We have focused on a healthy mix for client accounts. We have some stocks that have great growth potential such as TESSCO Technologies (TESS) and Kohl’s (KSS). We have some stocks that pay higher dividends such as Navios Maritime (NMM) and National Heathcare preferred (NHC-A) which can help limit our downside risk. Lastly, we have some big name companies that offer stability but continued growth potential such as Wells Fargo (WFC) and United Healthcare (UNH). The one thing we will keep an eye on is the risk tolerance of investors. If it appears that investors are reducing their risk tolerance, then look for us to become more defensive in our holdings.

As always, we do truly appreciate the trust that you have placed in us with a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.

Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(410) 864-8746
(866) 857-4095