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After surging in 2013, markets take a breather

bill rutherfordAfter 2013, when the markets packed three years of returns into one, they stumbled out of the gate in 2014. In January, the Dow Jones industrial average was down 5.3 percent, the S&P was down 3.6 percent and the Nasdaq was down 1.7 percent.

The four biggest stock markets – U.S., U.K., Europe and Japan – all were down. It was the first time they have had simultaneous declines for January since 2010, when the eurozone debt crisis was at its highest.

Some investors warned that the shaky start to 2014 meant that the markets were in for a down year. According to the stock trader’s almanac, when the S&P drops in January, it finishes the year up about half the time; that means January is no better than a coin flip as an indicator.

Emerging markets were the hardest hit, with huge withdrawals from the markets of developing countries. This withdrawal was the result of the confluence of several factors. With the U.S. Federal Reserve tapering its bond purchases, allowing interest rates to rise, U.S. debt markets became more appealing to investors seeking yield even as bonds’ values declined. As a result, money was repatriated back to the U.S., which put pressure on emerging market debt.

With capital outflows, emerging market currencies suffered, which in turn put pressure on emerging-market equity markets. It was simply too much for these smaller economies. As investors withdrew money from emerging markets, repatriation fed on itself.

Investors sought a safer, and better yielding, investment in the U.S. While Treasurys rose, yields in the U.S. declined. U.S. equity markets declined because of fear. Short-term investors headed for the exits. There was no sign of panic as longer term investors held fast. Hedge funds – fast money – hit the rip cord.

The Institute for Supply Management said its broad index dropped to 51.3 from 56.5 in December, the biggest drop since 2011. Any reading above 50 means the manufacturing sector is expanding. Part of the decline was explained by unusually bad weather, so it is hard to know what weight to give these readings, but they nevertheless hurt the market.

There have been years in which the market had strong gains in spite of January declines. In 2003, the market rose 26.4 percent after a 2.7 percent loss in January. In 2009, the market opened the year with an 8.6 percent loss and then rose 23.5 percent for the year, igniting the new bull market that has now run 850 days without a correction of 10 percent or more. On average, the market will correct 10 percent or more every 230 days. We are due for a pullback.

Of course, the emerging-market weakness could spread to Europe. Deflation is possible in Europe. A monetary policy mistake such as raising rates too soon, or tapering too fast, could also cause problems.

But the fundamentals do not support a worst-case scenario. Earnings growth, especially in technology and financial sectors, led the way in the new year. With half of the S&P companies reporting, analysts expect fourth-quarter earnings growth of 8.9 percent, the best in two years, and above previous expectations of 7.6 percent.

So far, 69.5 percent of companies reporting have topped expectations, with 20 percent falling short; that is better than normal. GDP in the U.S. rose at a 4.1 percent annual rate in the third quarter and 3.2 percent in the fourth, which helps explain the S&P rise of 29.6 percent last year.

President Obama, in his State of the Union address, made moving ahead this year a priority. He has his opportunity now that the State Department (yes, the State Department) has reported that the Keystone pipeline will not cause incremental environmental damage and will create thousands of jobs that are not government financed. This issue, which has been around for years, has become a symbol of this government’s reluctance to support business activity, while jobs and incomes have suffered.

A recent poll by IDB/TIPP of 910 adults in the period Jan. 25-30 showed that 49 percent thought the economy and jobs should be our No. 1 priority. To deflect criticism of the rollout of the Affordable Care Act, President Obama has tried to change the dialogue to income inequality, but only 6 percent of those polled agree with him.

Once again the stage is set for economic growth in the United States; the question is whether the government will lead, follow or get out of the way.

William Rutherford is the founder and portfolio manager of Portland-based Rutherford Investment Management. Contact him at 888-755-6546 or wrutherford@rutherfordinvestment.com.

About William Rutherford