Our Take on the Fourth Quarter

Morningstar

It would be a bit of an understatement to say 2013 was a good year for stock investors. Seemingly nothing, from the rapid rise in interest rates last spring as the Fed prepared to exit its quantitative easing programs to the government shutdown in the fall, could stop the bull market in 2013. The Morningstar US Market Index rose 33% in 2013 and more than 9% in the fourth quarter alone, while the S&P 500 and the Dow Jones Industrial Average hit all-time nominal highs.

The biggest story in the fourth quarter, and for 2013 for that matter, was the Fed's quantitative easing program. The market was fixated for months on the timing of the central bank's exit from its signature program. Starting in the first half of the year, chairman Ben Bernanke began discussing the possibility of tapering the purchases of securities in the face of improving economic data. The discussion in May led to a sharp and sudden increase in Treasury rates as the 10-year Treasury yield moved from 1.7% at the start of May to 2.2% in less than four weeks. The move in rates set off a communication campaign by the Fed to convince the market that they would not begin the taper until the economy was strong enough to support it and that short-term rates were going to remain extremely low for the foreseeable future.

The PR campaign seemed to have worked for the stock market at least. By the time Fed officials announced in December that they were going to reduce the size of their bond purchases by $10 billion a month, the market reaction was quite muted as investors had already priced in the taper. However, interest rates continued to rise in the fourth quarter, with the 10-year Treasury rate touching 3% just before the end of the year. This story is far from over. The Fed still has a long way to go to exit all of its extraordinary measures. And if 2013 showed us anything, it was that it's incredibly difficult to predict how the market will react to the Fed's moves in the years to come. Just like there was no road map for putting these interventions into place, there is no clear path of how to exit them.

Monetary policy wasn't the only game in town this year in Washington; fiscal policy played a central role, as well. Both sides of the Legislative aisle were able to come together to strike a last-minute deal to avert the worst of the fiscal-cliff tax hikes and spending cuts, but by October, the government shut down and flirted with breaching the debt ceiling again. The 16-day shutdown came to an end with another bipartisan deal that laid the groundwork for a subsequent deal that will fund the government for the next two years. The good news for investors is that after years of shakiness, the budget deal reached at the end of the year will provide a level of certainty over fiscal policy for some time. The bad news is that even though the near-term budget deficit is falling, the long-term entitlement issues remain unresolved.

The backdrop against which the Fed and Congress were making decisions was a slowly improving domestic economy. Morningstar director of economic analysis Bob Johnson estimates gross domestic product expanded 2.3% in the year, slower than that of previous recoveries but above the 2.0% growth rate we've seen the previous two years. Job growth was lumpy but consistent as the unemployment rate fell to 7%. Johnson sees a continuation of the slow-growth theme in 2014.

The municipal-bond market had an unusually active year. The capstone was Detroit's municipal bankruptcy filing in June, the largest-ever such filing, which a Federal judge ruled could proceed in December. Morningstar municipal credit analyst Elizabeth Foos called the filing a "watershed event" that could set important precedents for other highly indebted municipalities. Puerto Rico's financial woes also were a hot topic of conversation throughout the year. Despite the headlines, Foos noted that the overall credit quality of the muni market as a whole "remains generally sound" and that she does not expect a rash of new bankruptcy filings.

Of course there was plenty of news outside of the United States, too. Japan woke from its slumber during the year with the launch of Abenomics, the three-pronged plan of prime minister Shinzo Abe to help jump-start the Japanese economy. Although still early days, the plan to lower the value of the yen has been successful (you could buy JPY 87 for a dollar at the start of the year versus JPY 104 now) while the Nikkei rose 57% during the year.

In Europe, the euro crisis remained mostly silent as leaders worked on plans (unsuccessfully so far) to try to fix some of the systemic issues that face the common currency. European economies also seemed to have turned the corner out of recession and back to very slow growth.

China had an uneven year as the country struggled with how to move from an investment-led economy to one driven by consumer demand. Growth seemed to have picked up somewhat in the fourth quarter.

There were a handful of high-profile IPOs during the year. Twitter (TWTR) grabbed the most headlines, but other notable offerings included Hilton Worldwide (HLT), Zoetis (ZTS), and Quintiles (Q).

Sector-by-Sector Performance
All sectors, except for real estate, which lost 1.19%, rose in the fourth quarter. Technology (up 12%) led the way, with communication services (up 9%) coming in the number-two slot. A rough rollout of the Affordable Care Act didn't stop health care (up 9%) from rounding out the top three.

For the year, tech was far and away the best performer, gaining an astonishing 60%. Consumer cyclical and health care were each up 40%, while communication services, industrials, and financial services rose more than 30%. The only sectors that didn't post double-digit gains were real estate (up 8%), which was bogged down by interest-rate concerns, and basic materials (up 6%).

The sharp runup in stock prices led to many concerns about stretched valuations across the market. We still think the broader market is only slightly overvalued; however, some of the high-flying sectors have become quite pricey. Tech now looks 15% overvalued, while industrials and consumer cyclical are each 10% over fair value.

After posting the best performance among open-end sector equity funds in the third quarter, equity precious metals was the worst performer, losing nearly 14% in the fourth quarter. Industrials (up 10%), financial (up 9%), and technology (up 9%) were the best performers. For the year health (up 48%), industrials (up 42%), and consumer cyclical (up 38%) were on top. Equity precious metals (down 48%), real estate (up 2%), and global real estate (up 3%) were the worst-performing categories in 2013.

International-equity funds as a whole trailed domestic-equity funds in the fourth quarter. India equity (up 12%) was tops in the quarter but among the worst for the year losing more than 10%. Europe stock (up 7%) and world stock (up 6%) also had good quarters. Latin America stock was the biggest loser in the quarter (down 3%) and year (down 11%). Japan stock (up 26%) was the best performer in the year, trailed closely by Europe stock, foreign small/mid-blend, -value, and -growth, and world stock.

Long-government bond funds were the clear losers in the fourth quarter and the year as rates moved higher ahead of the Fed's decision to reduce the size of its bond-buying program. The category was down 3.5% in the quarter and down 14.0% for the year. Inflation-protected bonds slipped 1.8% in the quarter and more than 8.0% for the year. Other categories, from emerging-markets bond (down 7%) to long-term bond (down 6%), also had challenging years. High-yield bonds had the brightest quarter (up 2.9%) and year (up 6.8%), while bank loan (up 5.6%) was the second-best-performing fund group in 2013.

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