Mapping out next year’s game plan

This year has been a great year for stocks — far better than most investment gurus predicted. In fact, if the S&P 500 finishes the year about where it’s been recently, it could be among the top 15 years for performance since 1928.

But the question investment advisers and their clients must contemplate is: What will 2014 bring? And the answer to that question will determine investment tactics going forward.

Should clients take some of the gains of this year off the table and re-balance their portfolios? Or should they let their winnings ride? If they have been underweight equities during this bull market, should they increase their equity commitments now or is it too late?

These are among the issues with which advisers and their clients must wrestle as the year comes to a close.

History will provide some guidance as they deal with their decisions. First, since 1927, there have been 26 years in which the stock market total return, as measured by the S&P 500, topped 20% (excluding 2013), according to Ibbotson Associates Inc.

In 17 of the years after 20%-plus-return years, the stock market had positive re-turns, ranging from 33.07% in 1997 to 5.97% in 1984. In nine of the years following, the returns were negative, ranging from -3.22% to -38.59%. Based on this history, a positive return next year is almost twice as likely as a negative return.

In fact, the odds are better than that because four of the negative years following strong positive years occurred between 1928 and 1939, the period around the Great Depression, and only five occurred between 1940 and 2012.

DOWN-YEAR DROPS MODEST

Further, the declines following strong positive years have been modest since 1940, with the worst being -11.87% in 1946. Since 1928, the worst decline following a strong year was -38.59% in 1937 following the 27.92% gain in 1936, once again in the midst of the Great Depression.

On the other hand, 20%-plus gains often have been followed by substantial gains the following year. For example, the 45.02% gain in 1954 was followed by a 26.4% gain in 1955. The 37.08% gain in 1995 was followed by a 22.64% gain in 1996, a 33.07% gain in 1997, a 28.3% gain in 1998 and a 20.87% gain in 1999.

Countering that history is the fact that after four or five years of steady gains, the market often has stumbled. For example, following the aforementioned run of gains from 1995 through 1999, the market had losses in 2000, 2001 and 2002. Likewise, in the 2003-07 period, which was followed by the 36.55% loss of 2008. Since then, we have had five positive years in a row. Time for another tumble?

How much weight can advisers and their clients place on this history? As John Maynard Keynes said: History repeats, but not exactly.

Investors (and their advisers) who have heavy equity positions can take some comfort from this history, and others might take it into consideration when deciding whether or not to increase their equity positions.

NOT SO FAST

But other factors should be considered. First, the economic recovery has been and remains slow, and corporations are not yet investing for the future. Government policies also are weighing on corporate investment decisions. At some point, low corporate investment must hurt future corporate profitability.

Second, the capital markets are awaiting signs that the Federal Reserve is ready to begin tapering its bond-buying activities. When tapering begins, it likely will negatively affect both the stock and bond markets — but by how much is anybody’s guess.

Third, Robert Shiller’s stock market valuation model, based on cyclically adjusted price-earnings ratios, is flashing signs that the market is overvalued, suggesting that investors should reduce their holdings. Many other analysts are suggesting that a 5% or 10% correction in the market is overdue.

Advisers should be discussing all of these issues with their clients as part of their year-end reviews, and debating what changes, if any, should be made to their portfolios for the next year and beyond.