Change of plan

IRRATIONAL EXUBERANCE EXPLAINED THE DEMAND FOR DOT-BOMB STOCKS. SCARED WITLESS DEFINED THE MOOD AS INVESTORS FLED EQUITIES DURING THE FINANCIAL CRISIS. WHAT ABOUT LAST YEAR? CAUTIOUSLY OPTIMISTIC DOESN’T QUITE EXPLAIN THE STELLAR RESULTS. LET’S CALL 2013

Stock market returns last year were so good that some pension fund managers are now thinking about what to do with surpluses, not deficits. In Canada, according to a recent Aon Hewitt report, the median solvency funded ratio for pension funds increased to 93.4% in 2013. Sponsor contributions and higher long-term interest rates helped improve the pension picture. But equity markets, especially in the United States, deserve most of the credit. As Aon Hewitt noted, equities gained 35.5% worldwide last year, when U.S. stocks posted a 41.6% return and Canadian equities jumped 12.7%. Outside North America, international stocks gained 31.3% and emerging market equities generated a 4.1% return.

With improving economic conditions in the U.S., Europe and Japan, not to mention a weakening loonie (which California hedge fund manager Vijai Mohan thinks could drop below US70¢ within five years), Canadians might be tempted to bet more of their nest eggs on U.S. stocks. But before anyone adjusts their portfolio, it is important to understand the driver behind last year’s impressive performance. After all, thanks to a lot of in-Bernanke-we-trust sentiment, investor demand, not corporate earnings, generated most of last year’s stock market gains — which helps explain why sharehold- ers were easily spooked this year by a combination of U.S. Federal Reserve tightening and bad news out of emerging markets.

As Money Game editor Sam Ro pointed out in a recent commentary, market forecasts are typically based on two factors: earnings and valuations. U.S. earnings estimates for last year were pretty accurate, but no one predicted the S&P 500 would close 2013 at a record high of 1,848. At the start of last year, the median forecast for the S&P 500 was 1,560. Simply put, pretty much everyone got the valuation side of the equation wrong. And as stock prices outpaced earnings growth in 2013, the S&P 500 price-to-earnings ( P/E) multiple expanded to more than 19x trailing- 12- months ( TTM), up from about 17x at the start of the year. The P/E multiple dramatically increased for many stocks during the financial crisis because corporate earnings dropped faster than stock prices. The historic average is about 15x.

As January came to a close, the S&P 500 had dipped below 1,800, but stocks were still not cheap. Even if the U.S. bull market isn’t tripped up by market turmoil in places such as Turkey and Argentina, central banks or some black swan event, investors should note that increased market nervousness means earnings growth will likely play a larger role in determining return levels this year.