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.


Shaping a portfolio for 2014 (iv): interest rates

the current situation in the US

The first time I visited Taiwan, in 1985, I was struck by the presence of armed soldiers–bayoneted rifles at the ready–at the toll booths on the highways.  It turned out Taiwan had been in an official state of emergency, guarding against possible invasion from the mainland, for a very long time.  The reality of the 1980s, however, was that the Peoples Liberation Army didn’t have enough boats to launch an invasion.  Also, what trucks they had would have broken down on the way to the ports, leaving would-be invaders scattered in small groups around the countryside and forced to hitchhike back to their bases.

Monetary policy in the US is a lot like the Taiwanese state of emergency–except that the Fed, through Quantitative Easing, continues to issue its metaphorical soldiers ever-longer bayonets and more bullets.

It wants to stop doing that, by “tapering,” or decreasing the rate at which it pumps extra amounts of money into the US economy.  It doesn’t want to roll back the state of emergency–by raising short-term interest rates from the current zero to a “normal” 4% or so–for at least two years.  The process of normalization itself will presumably take several years to complete.

economic consequences

The current situation is great for anyone who wants to borrow money.  It’s horrible for savers (read: senior citizens).

The Fed is not maintaining its state of emergency because it thinks the economy is too weak to tolerate higher rates.  Rather, its “dual mandate” from Congress legally binds it to try to fight the current high level of unemployment, a task that normally falls to fiscal policy from the administration and Congress.

The failure of fiscal policy–normally public works construction + worker retraining–means that financial incentives are skewed in a potentially harmful way.  Also, the Fed has nothing left in the tank to respond to any new emergency that may arise before rates are back up to normal.  We’d have to depend on the administration and Congress.  But that’s the world we live in.

investment implications

Two opposing forces:

–the Fed has no intention of raising rates for a long while, but

–raising, earlier this year, the possibility of starting to slowly wean the economy from ever-accelerating expansion of the money supply signaled that the thirty-some year era of continually looser money policy–with its accompanying ever-lower interest rates, ever-higher bond prices–is over.  The next move, when it comes, is a reversal of form.  Higher rates, lower bonds.

My take:

–in past times of post-crisis rate normalization, bonds have gone down, stocks have gone sideways to up

–historically, a turn in the price of any commodity comes in two phases.  The first is anticipatory, as the market perceives a change is likely.  That’s followed by a volatile sideways movement, which ends when the commodity begins to rise in price.  That’s my best guess of what will happen with interest rates and bond prices–trendless volatility.

–the present crop of professional traders don’t strike me as being particularly astute students of history.  Few will have actually experienced during their professional careers an extended period of Fed tightening.  No one has seen a Fed tightening of the peculiar type we will be undergoing in coming years.

We’ve already seen the anticipatory move in bond prices.  The Fed thought it was irrational enough that it spent months unruffling traders’ feathers.  It’s possible that next year the trading community will make the ride bumpier than it needs to be.

Shaping a portfolio for 2014 (iii): outside the US

For an equity investor, the two most important geographical areas outside the US are Greater China and the EU.  Japan is arguably a third, although in today’s world it’s more a cautionary tale about the horrible consequences when an aging population, inflexible businesses and dysfunctional government conspire to retard change.


An impending once-a-decade leadership change in the Communist Party slowed the Chinese economy this time a year ago.  Business and government both kept a low profile while waiting to see what the new administration in Beijing would bring.

Handing over the reins this time also came at a delicate point in Chinese economic development.  The mainland has reached the limits of its ability to expand based on exporting products made with cheap labor.  To grow in a healthy way, it must shift more toward domestic demand, consumer spending-driven expansion.  This change is notoriously difficult for any developing economy to achieve, both because the forces eager to maintain the status quo are so powerful and, especially in the case of China, the move entails loss of direct control by the elites and the empowerment of individual consumers.  Not fun for the CCP.

For the new leadership, so far so good.

For investors, the thing to focus on in the near term is that growth in the mainland is accelerating–although GDP gains will likely stay at “only” +7% or so real.  It doesn’t hurt, either, that demand from the US and the EU for Chinese exports is rising again.

The mainland stock markets are no longer the dumping grounds for the shares of toxic state-owned enterprises that they were a decade ago.  Nevertheless, I think the two best ways to gain exposure to China are either to buy China-oriented stocks listed in Hong Kong, or to get indirect exposure through US- or EU-based multinationals with a large share of their earnings growth coming from China.  Either way, having a piece of the mainland in an equity portfolio will be a good thing next year.


Taking a long-term view, the EU population is older than that of the US and substantially less mobile.  The economy there grows more slowly.  The lack of a common banking system is one of a number of severe structural flaws in that union which the EU is struggling to overcome. Although the EU was only on the periphery of the US home mortgage debacle that caused the Great Recession, its “austerity” approach to countering the effects of the downturn made the EU’s problems worse–and longer-lasting.

Still, the EU has its moments.  This is one of them, in my view.  The EU economy passed its economic low point a number of months ago.  It will be expanding, although probably slowly, for the next several years.  In a sense, it’s where the US was in, say, 2010.  In addition, the EU will be aided by mutually reinforcing  expansion in China and the US.

So having some EU exposure will be a good thing.

The key issue for investors, I think, is whether the euro will be strong vs. the US dollar or weak.  In the former case, the best stocks will be domestic demand-oriented EU firms and US companies with large EU exposure.  In the latter, the stars will remain the export-oriented multinationals based in the EU that have outperformed over the past several years.  I think the euro will be strong–not overpoweringly so, but enough to tilt portfolio selection toward strong-euro beneficiaries.


Abenomics will face its acid test in 2014, I think.  If Abenomics is only about currency depreciation and deficit spending without the “third arrow” of structural change, it will end in tears.  That’s my diagnosis.  On the other hand, I’ve been completely wrong so far, missing about the huge extent of the rise of weak-yen beneficiaries over the past year or so.  As I see it, weak yen = great vacation destination, but nothing more.  For the sake of Japanese citizens, I hope I’m wrong again.  For the first time in a long while, I own nothing in Japan.



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.