Monday, December 16, 2013

The Positive Case for U.S. Stocks in 2014

Our assessment of the U.S. economy and stock market conditions leads us to conclude that the 4+ year bull market in stocks, which includes an S&P 500 surge of 25% in 2013 through December 16 and a 160% gain since March 2009, will continue through 2014. We predict an advance of 7-9% in the S&P 500, which would be in-line with a 7-9% jump in corporate profits. A double-digit increase is possible if the “multiple expansion” of 2013 extends into next year. Corrections are a normal characteristic of bull markets, and some believe that the current market is overdue for a 10%+ setback, but we would view such a correction as a buying opportunity unless there is a change in the following favorable economic
and market conditions:

  • We expect U.S. GDP growth to increase 3% in 2014, which is in line with the Federal Reserve’s forecast and a December 5 Bloomberg survey of economists. This economic growth will likely result in corporate profit growth of 7-9%. Thomson Reuters Baseline reports that the consensus projection is 8%.
  • Fundamental to our upbeat economic forecast is low inflation and a continuation of the Federal Reserve’s accommodative policy that includes near zero short term interest rates until at least 2015.
  • The market remains fairly valued despite the significant gains in 2013. The current S&P 500 P/E ratio of 16.4% is only slightly above the long-term norm of about 15%.
  • A major stock market development in 2013 was that stock prices rose over 20% when corporate profits grew less than 5%. The “multiple expansion” which resulted is characteristic of a maturing bull market and may well extend into 2014. This would raise the 2014 market advance into double-digits.
  • Money market funds and bonds remain relatively unattractive. Money market funds yield at or near zero and are likely to remain low due to Fed policy. Bond yields are historically low and Federal Reserve tapering is expected to result in higher bond yields (and lower bond prices).
  • Data compiled by Strategas indicates that the 4+ year bull market through this November has resulted in an outflow of $370 billion from stock mutual funds, whereas they report an inflow of $985 billion into bond mutual funds. Improving economic conditions and a rising stock market could convince investors to reverse these flows. A “Great Rotation” could occur in 2014 as investors shift from bonds to stocks.
  • Stock markets have a history of climbing a wall of worry. A November 26 Merrill Lynch report on investor sentiment indicates that confidence remains at the same level as at the depths of the bear market in early 2009. Some skeptics argue that the market is now in a bubble condition, which we think untenable when there is such a high level of pessimism.
  • Corporate cash balances remain very high. Improving economic conditions may induce corporate managements to increase dividends, stock buybacks, and merger and acquisition activity, all of which are positive for stock prices.
A relevant consideration in our market forecast is that the level of risk in the U.S. market is reduced from prior years. The possibility of a relapse into recession is diminishing as foreign economies expand and geopolitical tensions moderate. Investor concern with dysfunction in Washington has declined significantly over the past two years, with neither political party willing to appear obstructionist as a
general election approaches.
We view the upcoming, widely anticipated reduction in the Federal Reserve’s bond buying program (tapering) as a threat to the U.S. market. The fear is that tapering will force rates up to such an extent that it will choke off the housing industry, discourage consumers, and trigger a possible recession in an economy that has yet to restore full health. We think this is unlikely because the Federal Reserve is highly sensitive to declining growth and would adjust its policy if this outcome seems possible.
Despite the fundamental economic and market positives, there is a nagging suspicion held by many investors that something ominous is on the horizon. This view is often based on an awareness that the
average duration of past bull markets is about 5 years and the current bull market is approaching this point. Markets do not operate on a preset clock and we encourage investors to base their strategies on empirical conditions. Underlying economic fundamentals are much more reliable predictors of market tops, and they are currently propitious.
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