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.

Bond Market Considerations

At the beginning of the year, we alerted readers of our Outlook to be sensitive to the risks of investing in U.S. Treasury, corporate, and tax-exempt bonds. Our view rested on the historically low yields provided by these bonds at a time when the economic expansion was maturing and inflation was looming. We were also concerned about the U.S. government’s massive budget deficit and approaching debt ceiling deadline, highlighted recently by warnings of potential downgrades from credit agencies, and the very weak fiscal circumstances of many tax-exempt issuers. Our advice was to keep credit high and maturities short.       

                 

To our surprise, the yield on the benchmark 10-year U.S. Treasury note has declined from a high of 3.74% on February 8 to 2.95% on June 8, and corporate and tax-exempt yields have correspondingly declined. We attribute this drop in yields (and rise in prices) in part to growing uncertainty regarding the duration and severity of the current global economic “soft patch,” which has triggered an exodus from equities and a flight to the perceived safety of bonds in general and U.S. Treasury securities in particular. Another contributor to sliding yields has been the determined effort of the Federal Reserve to alleviate fears of inflation and keep rates low in hopes of accelerating economic growth.

Our forecast, shared by a consensus of economists, is that the “soft patch” will be relatively short and innocuous, as was the case with a similar “soft patch” at this time last year. A restoration of more healthy economic growth will most likely heighten inflation anxieties. We also expect the Federal Reserve’s “quantitative easing” policy (QE2) of purchasing Treasury securities to support low yields to expire in June and not to be extended.  Further, we expect worries about the U.S. government’s deficit to intensify as the debt ceiling deadline approaches. As a consequence, we reiterate our strategy of maintaining high quality and short maturities in U.S. bonds even though lower quality and longer-maturity bonds currently provide higher yields. We also suggest that readers consider the appeal of international bonds as an addition to U.S. bonds.

Our recommendation is echoed by Bill Gross, the celebrated manager of Pimco’s Total Return Fund, which is the world’s biggest bond fund. Gross, who according to  Bloomberg (6/9/2011) has outperformed 99% of his rivals over the past 5 years, eliminated U.S. government debt from his portfolio in February. Stating yesterday “I certainly don’t have any regrets,” he repeated his prediction that the 30-year bull market in bonds is over. Rather, he encouraged investors to consider the bonds of other countries with stronger balance sheets and half the debt. In particular, he cited the bonds of Germany, Canada, and Brazil, which have higher yields and he believes are safer credits, as “better opportunities.” 

We point out that many factors need to be considered in evaluating the appropriateness and desirability of international bonds, and currency fluctuations will have a significant impact. Investors who want to control risk should favor intermediate-maturity, attractive-yielding sovereign bonds of countries with strong economies and currencies. We are currently reviewing portfolios on a client by client basis, and we strongly advise other readers to seek professional assistance in diversifying their bond holdings by taking a global perspective.