2013: The "Great Divergence" Between Stocks, Bonds, and Gold

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Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

In a fitting tribute to the strength and consistency of this year's bull market, both the S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) closed out 2013 at all-time highs, with annual price returns of 29.6% and 26.5%, respectively. The surge in stock prices has been broad-based, too – the small-cap Russell 2000 index put up even better numbers, rising 37% (it also closed at a record high on Tuesday.) For the S&P 500, that is the benchmark index's best performance since 1997; from its financial crisis closing low on March 9, 2009, it has now risen 173%.

Stocks have ridden the wings of the Federal Reserve's bond-buying program ("quantitative easing," or "QE), but, more recently, that motor has been replaced by a new air of optimism regarding the economy, as the data suggests that a self-sustaining recovery may finally be gaining traction. While the Fed's open-ended asset purchase program ought, in theory, to have been a positive catalyst for gold, it is now clear that the third round of QE had been (more than) priced in at the end of 2012 -- the Fed had only recently more doubled the size of the QE3 monthly bond purchases (Dec. 12).

Runaway inflation never materialized, nor did the currency collapse, as certain gold enthusiasts were predicting; indeed, the Fed has -- so far -- done a remarkable job of managing its unprecedented monetary experiment. With this month's decision by the Fed to begin curtailing the pace of its bond purchases (albeit very gradually) reflecting increased confidence in the economy, combined with an apparent decrease in "tail risk" in Europe -- well, the trend for an asset that represents a hedge against Armageddon is clear. Gold futures prices fell 28% this year, as the yellow metal recorded its worst rout since 1981; barring a major crisis next year (which can't be ruled out, of course), gold has further to fall in 2014.

The same could be said for Treasury bonds -- the 10-year Treasury yield ended this year at 3.02%, its highest level since July 2011 (bond yields move inversely with prices). If the economy gains further momentum and the Fed continues to taper, both of these factors ought to lead to further increases in bond yields as the bond market anticipates higher growth (and emerges from under the distortions of the Fed's actions).

After a banner year, will stocks be the winning asset class in 2014? Perhaps, but investors ought to dial back their expectations -- a repeat performance of this year is highly unlikely and, current valuations suggest some of this year's returns may have been borrowed from the next.

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