Shaping a portfolio for 2014 (v): putting the pieces together

Late March of 2014 will mark the end of year five and the beginning of year six since the bottoming of world stock markets after the 2007-2008 equity collapse.  The second half of the year will mark the same low point for world economies.

Given the very strong stock market performance of 2013, as well as the length of time since the market bottom, one’s first instinct for 2014 is to be cautious.  More than that, based on past market patterns, common sense says that in year six of expansion one should be on the alert for the next possible downturn.

Nevertheless, I think there are several strong positive elements in the current stock market situation:

–world economies are likely to continue to expand in 2014.  The rate of positive change will be strongest in the EU, although this is also an observation about numbers close to zero.  China appears to be over its regime-change slowdown.  Importantly, the new administration is trying to make a structural shift away from export-oriented growth toward domestic consumption, implying that the usual yardsticks investors use to measure China may not be as reliable as in the past.  The US continues to be surprisingly resilient.

–interest rates will stay ultra-low for at least the next couple of years.

–at 16x projected earnings of $110, the PE on the S&P 500 is reasonable.  Based on the behavior of securities markets over all but the first couple of years of my career, a PE of 16 would be consistent with a long Treasury yield of around 6%.  In other words, today’s market PE already factors in all the interest rate tightening that will happen over the coming rate normalization cycle.

My bottom line:

–stocks will have a typical up year in 2014, driven by advancing earnings, of about +7%-8%.

–growth outside the US will likely be better than inside the US for the first time in several years, meaning portfolios should move away from a domestic-only bias.

–stock selection in the EU is the only really problematic issue I see.  It’s unclear whether strength will mostly be reflected in upward movement of stock prices in euros or in an advance of the euro vs. the dollar.  In the latter case, domestic EU-oriented stocks will be the stars and export-oriented/multinational names, which have been serial outperformers since 2009, will lag significantly (this is my basic assumption).  In the former, I think domestic outperformance will still be there, but will be less crucial to stock selection.

–growth names usually outperform their value counterparts as the business cycle matures.  That’s because the surge of extra consumption deferred during recession, and which speeds the profit growth of cyclical stocks, abates.  So secular growth stocks show superior earnings expansion.  I think this will prove true again in 2014.

–this time, however, the dividing line between outperformer and underperformer is probably going to be south of +10%.  So high dividend-yielding stocks, which have been relatively crushed this year (read:  up maybe 10% in a market that’s up 30%), have a chance to redeem themselves in 2014.  I’ve already suggested MSFT as a possibility.

–short-term volatility could be high.  My guess is that any short-term downdrafts will be triggered by (crazy, in my view) worries about Fed tapering.  Generally speaking, though, stocks rarely go sideways for extended periods of time.  If I’m right that the upside for the S&P is less than/around 10%, any advance creates a situation where stocks, at least temporarily, have only one way to go.  On the other hand, low interest rates + good profit growth will limit possible downside.


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