2013 In Review

2013 was a great year for stocks and a mixed year for bonds.  We saw improving economic data and are left with many unanswered questions out of Washington DC.  Let’s take a look.

Markets:

2013 was a spectacular year for developed market stocks, especially in the United States.  Large cap US stocks (measured by the S&P 500) gained 10.51% in the fourth quarter alone, ending the year with an annual gain of 32.39%. US small cap stocks (Russell 2000) were even better with an annual return of 38.82%. International stocks were mixed, with developed markets (MSCI EAFE) gaining 22.78% but emerging markets stocks (MSCI EM) down -2.60% for the year.  Bonds were also mixed, with the broad Barclay’s Aggregate Bond index showing a loss of -2.02% for the year, while short-term and corporate bonds held up better at flat to slightly positive.  With the spike in interest rates this year, short-term bonds outperformed long-term bonds across asset classes.

Economy:

Economic data continued its modest improvement during the fourth quarter and throughout 2013. Employment data and broad economic growth both steadily improved throughout the year.

The headline unemployment rate dropped to 7% at the end of the year, down from 7.9% in January. While labor force participation has also dropped, this gradual improvement is still good news.

The economy in the US grew steadily in 2013, with average growth during the year above 2.5%.  This is still below the typical growth level of a post-recession recovery.  Much of this slower rate of recovery can be attributed to consumers digging out of heavy debt burdens and rebuilding balance sheets, as we’ll see below.

Households and individuals are now in better financial shape than any time in the last decade. Household net worth has recovered above pre-recession levels:

And consumer cash flows have improved, with US households spending the smallest allotment of disposable income on debt service in any time in the last 30 years. This means improved balance sheets and more free cash flow available for consumer spending and investment.

Finally, the US federal budget deficit is shrinking thanks to a combination of the improved economic environment and the sequester spending cuts.

In Washington:

As 2013 came to a close, Congress allowed for the expiration of 55 tax breaks. Some were small and obscure, but many will affect individuals, retirees and small business owners.  Among them are:

• Section 179 deduction for small businesses buying equipment will fall from $500,000 in 2013 to just $25,000 in 2014;
• Deduction for state and local sales taxes will no longer be an option (taxpayers can still take state and local income taxes as an itemized deduction);
• Tax-free charitable distributions from IRAs for account holders over 70.5;
• Home energy efficiency improvement tax credits;
• College tuition payment tax deductions.

Of course, it is possible that these breaks will be retroactively reinstated in the near future, as has been the case several times in the recent past.

And lastly, let’s not forget that 2013 was the first full year for the increase in the highest marginal tax rate (from 35% to 39.6%) and the increase in capital rates rates (15% to 20%) and the addition of the investment income surtax of 3.8%, which applies to capital gains and dividends. These increased taxes make tax loss harvesting and tax sensitive investing all the more important in the future.

Of course, no one knows what 2014 will bring. But in the long term, investors will be best served by not speculating about the near future and instead investing with purpose with the help of an investment policy statement and rational, sensible behavior.