Shaping a portfolio for 2014 (ii): the US

more of the same

The economic underpinnings of the US economy appear to be strengthening, not flattening or weakening.

New hiring is rising at a slow, but accelerating, rate.  Consumer confidence is up.  Financing costs remain extremely low.  The result of all this has been a continuing domestic boom in housing and in consumer durables.  On addition, other major world economic zones–the EU, Greater China, and, at least for the moment, Japan–are now all improving together for the first time in five years.

Some simple stock market arithmetic:

US profit gains =50% of the S&P     rising at a 5% annual rate in 2014

EU profit gains = 25% of the S&P   rising at a 2% annual rate in US$ (some combination of currency gain + profit growth)

Pacific Basin  + everything else = 25% of the S&P  growing at a 10% annual rate

Total = 8.5% profit growth for S&P 500 profits in 2014.

just not as much as in 2013

The S&P 500 entered 2013 at 1406, or just under 14x expected earnings for 2013.  If the year ended today, it would be entering 2014 at 16,5x my expectation for earnings in 2014.  In other words, as I mentioned yesterday, the main factor powering the S&P this year has been price earnings multiple expansion.

I don’t think we’ll see similar PE expansion in 2014.  If I’m correct, what will move the market upward will be earnings gains.  If my back of the envelope calculation above is close to the mark, the S&P will be somewhere in the vicinity of 1950 a year from now.

Why not better than that?

Two related reasons:

1.   As liquid investments, stocks and bonds are in many ways substitutes for one another.  Because of this, the price of one has an influence on the price of the other .  The traditional (and correct, in my view) way of comparing the two is to look at the interest yield on government bonds vs. the earnings yield (1/PE) on stocks.  If long-term government bonds would be yielding around 5%-6% in a normal interest rate environment, the PE on the stock market should be 17x – 20x.  That’s very close to where we are now.

In my view, this means there isn’t a lot of room left for PE expansion.  Yes, my guess on long-term government bond rates may be too conservative.  Yes, PE expansion may happen anyway.  I’m just not counting on it.

2.  Financial markets are futures markets.  The reflect in today’s prices expectations about how the future will play out.  And the process of interest rates rising from emergency-low levels has already begun.  Mr. Bernanke put the topic on the table with his discussion of the timetable for “tapering,” or reducing the rate at which the Fed pumps out extra emergency monetary stimulus.  In the past, times like this have typically been bad for bonds, flattish for stocks.

looking for outperformance

1.  My friend Denis the bond guru sent me an email the other day asking:  today do you want to buy/own the asset that’s up by 45% over the past two years (the S&P) or the one that’s down by 10% (the 10-year Treasury)?  HIs answer is the latter.  He also thinks rates are going down.

Personally, I’m sticking with stocks.  But Denis’s note highlights to me how badly bond-like (that is, dividend-oriented) stocks have fared recently.  I think the whole utility, telecom, MLP area is worth a look.

2.  As I wrote recently about MSFT, I don’t think the bar for outperformance is going to be particularly high next year.  So stocks  with strong traditional businesses like MSFT may attract a surprisingly large amount of investor interest.

The MSFT story is kind of flimsy:  a bad board of directors which has tolerated horrible mismanagement of the corporation’s assets over a decade has finally decided to replace the CEO; the new choice can’t possibly be as bad as the current guy.  Still, it’s difficult to imagine the stock going down a lot (unless the new CEO is, say, Carly Fiorina), and +20% doesn’t sound too crazy, given the fact the underlying business has survived the worst that the current cast of characters has done to it.

3.  Despite special situations like MSFT, so-so economies are usually environments where growth stocks outperform their value counterparts.  I think this will be true in 2014.  I also think it’s time to look again for US-based companies with large EU exposure or with substantial China-related interests.  I also expect consumer spending will continue to be highly focused–meaning people don’t have enough money to buy everything the want, so they’ll be very choosy.  I’m looking for stuff Millennials will buy, rather than Baby Boomers.

4.  For what it’s worth, the only people I know who called 2013 correctly are the S&P equity strategists.   They think we’re due (or overdue) for a 5%-10% correction shortly.  If nothing else, that might be further motivation to do yearend portfolio housecleaning.

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