Despite a series of boulders thrown in its path, the market has managed to march steadily higher throughout 2013.
The 23% gain for the S&P 500 Index thus far in 2013 is higher than even the most bullish forecasts anticipated. Yet a look at why the market is reaching new heights can give us a clear read into what to expect in the year ahead.
The S&P 500 has risen in eight of the past 10 months
Here's a look at five key themes from this year, and what to expect in 2014.
|1. The Fed's long-awaited tapering|
|For the past six months, the Federal Reserve has inched ever closer to ending the massive quantitative easing (QE) program that has pumped $85 billion into the economy every month. The Fed seemed poised for an imminent move in the spring, which led the markets to slump in late May and early June. The fact that Fed decided to wait a bit longer led investors to conclude that it was still safe to buy into a liquidity-fueled market.
Few have expressed concern that the Fed's inaction is the result of an economy that just can't build a head of steam. Perhaps the fact that the economy is at least maintaining modest growth -- and not showing signs of a fresh recession -- is seen as a source of comfort.
Still, the end of QE is inevitable, with consensus expectations that the Fed will shift gears at the Federal Reserve Open Market Committee (FOMC) meeting held on March 18-19, 2014. If that happens, then stocks could start to slump in advance. As we saw last spring, investors began to sell stocks when they sensed that QE would soon end.
|2. The yield 'head fake'|
|Ahead of an expected Fed move this past spring, income-producing stocks began to take it on the chin, as the yield on the 10-year Treasury rose a full percentage point. Investors figured that rising interest rates, which would be one of the corollary impacts of the end of QE, would make dividend yields comparatively less appealing. Short sellers even began to place significant stakes against high-divided stocks and funds.
Of course, with the Fed never actually making a change, the yield scare eventually cooled down, leading these same short sellers to cover their positions against income-producing investments. But we now have a market tell: Once the Fed decides to act, dividend-paying stocks are again likely to rotate out of favor.
|3. Emerging markets: risk-on/risk-off|
|Investors fled emerging markets in droves this summer, as fears as falling Fed liquidity in the U.S. (with the end of QE) would cause a cash crisis in many countries that ran high trade deficits.
Yet as I noted back then, "the sharp pullback in places like Brazil, Australia, Turkey and elsewhere should be seen as opening for investors that have been awaiting better valuations in these markets."
Well, emerging markets have subsequently posted nice gains, with many of the exchange-traded funds (ETFs) rising 10% to 20% since the summer swoon.
The recent rebound for these funds, coupled with the fact that the Fed will eventually come back to spook global investors, means investors couldn't be blamed for locking in profits. I remain very bullish about emerging markets for the long haul, but there are continued signs of distress in places like Brazil, Turkey and Indonesia. I love where these economies will be in 10 years, but investors should brace for anemic economic growth rates in 2014.
|4. The oil gusher could really play out in 2014|
|Over the course of 2013, the U.S. has been steadily and rapidly expanding domestic oil production, consuming fewer oil imports with each passing month. The fact that our nation's automobiles are ever more fuel-efficient also changes the global dynamics for oil supply and demand.
Still, oil prices stayed firm this summer as West Texas Intermediate Crude (WTI) remained above $100 a barrel. It seems as if reality has finally begun to set in. Crude prices have dropped more than 10% over the past six weeks, and recent inventory trends imply further drops ahead. According to The Wall Street Journal, "Total (crude oil) stockpiles of 383.9 million barrels are at the highest level since late June and the highest amount since the Energy Information Administration began tracking the data in 1982."
Falling crude oil prices are providing badly needed relief for consumers, as gasoline prices have fallen to 11-month lows. Airlines will also feel relief from lower jet fuel prices, and home-heating bills this winter could also get a break.
Notably, the U.S. energy sector has plans for big output gains in 2014 and 2015 as well, and a year from now, we may be talking about $70-a-barrel crude oil.
|5. Small-cap biotechs are imploding|
| Investors embraced biotech stocks in a big way in 2012 and much of 2013. But in recent months, the large-cap biotech stocks (such as Celgene (Nasdaq: CELG), Gilead Sciences (Nasdaq: GILD), Amgen (Nasdaq: AMGN) and others have continued to bounce near all-time highs, while dozens of smaller biotechs are now in the midst of a deep slump.
Why the dichotomy? Because these smaller biotechs are often cash-starved. And in the financial crisis of 2008, they failed to shore up their balance sheets in time and had to endure massive dilution to reload with cash.
Investors are clearly again concerned about cash-burn rates, though it's not fully clear that the current era holds great parallels to 2008, when the capital markets were slammed shut. Still, before you buy that next biotech, make sure it has enough cash on hand to cover 24 or even 36 months of clinical trials.
Some of my favorite small biotechs that have recently sold off but have ample cash on hand include:
All of these biotechs are far from their 52-week highs but are expected to make clinical trial progress in 2014.
Risks to Consider: The real risks for stocks in 2014 are the ones we can't see. It likely won't be a Washington-induced mess or a fresh crisis in Greece. Investors are already desensitized to those threats. Instead, it's the "unknown unknowns," as Donald Rumsfeld would say, or the "Black Swans" that Nassim Taleb would mention.
Action To Take --> Here's a bold prediction: The market won't rack up the gains in 2014 that it has in 2013. There are limits to how far this Fed-induced liquidity rally can go, and unless corporations can markedly expand profit margins from already high levels, then corporate profit growth is likely to be too anemic to justify much more upside.