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Thursday, January 2, 2014 - 14:30

Your Roadmap For Stocks In 2014

Thursday, January 02, 2014 2:30 PM

Forget almost everything you learned about investing over the past few years.

The past 48 months have been characterized by sluggish U.S. economic growth, a helping hand from the Federal Reserve, global scares, and a steadily rising U.S. stock market.

Yet as we head into 2014, many of these variables will no longer apply -- and how you adjust to these changes can spell the difference between profits, losses or merely capital preservation.

Sustainable 3% Growth?
The U.S. economy surged an impressive 4.1% in the third quarter, thanks in large part to inventory restocking. That led economists to assume that fourth-quarter GDP growth would be notably weaker, especially as further inventory stocking was unlikely.

Yet in recent weeks, it's become apparent that the economy is on track for a second straight quarter of robust GDP growth. Economists at Deutsche Bank now anticipate 3.8% GDP growth in the quarter just ended (which they will revise after digesting an international trade report due Jan. 7).

Two consecutive quarters of GDP growth above 3% is quite unusual. It's happened only once in the past five years (the fourth quarter of 2011 and the first quarter of 2012). The economy subsequently rose, on average, just 1.1% over the next four quarters.

This time around, the economy's momentum looks to be more sustainable, and the chances that we'll hit another economic "air pocket" in coming quarters appear more remote. Companies are beginning to invest more heavily in capital equipment -- a key theme you'll be hearing about in the coming earnings season -- and increased business investment brings many associated benefits in terms of employment and supply chains.

Indeed, the employment picture is also emerging as a real bright spot. The economy created 180,000 jobs in October and 203,000 in November, and economists are looking for a similar figure when the monthly employment report is released Jan. 10.

When was the last time the U.S. economy created 180,000 jobs for three straight months? The first three months of 2011. But that trend couldn't be sustained as a deepening recession in Europe and chaos in Washington blunted the U.S. economy as the year played out.

This time just seems different. Europe is showing tentative signs of growth, and Washington is staying out of the way -- for now.

Economists at Deutsche Bank predict that the national unemployment rate will drop to 6.4% by the end of 2014. To put that in context, the national unemployment rate stood at 5% at the start of 2008 and was above 7% by the end of that year on its way to 10% in 2009.

The Impact On Stocks
In recent years, the Fed's distorting hand had severed the connection between economic activity and stock prices. But with the Fed slowly receding from the picture, future stock market performance will depend more squarely on economic activity and profits.

In light of the market's remarkable gains recently, it's hard to gauge whether much of the good economic news to come has already been priced into stocks. But by a variety of indicators, stocks appear to be reasonably valued.
The key takeaways: Compared with the prior two market peaks, companies now carry far lower levels of debt, and stocks now operate in an environment of much lower interest rates.

Prior Market Peaks

Will rising interest rates sap the momentum for stocks? Few expect to see the 10-year Treasury note move above 4% in 2014, and as long as that's the case, stocks need not worry about such rate pressures. "Low but rising interest rates have historically been good for stocks, and bull markets have generally persisted during the early stages of tightening," note economists at Merrill Lynch.

Instead of interest rates, the real focus will be on the rate of U.S. economic growth. Many companies will be setting their 2014 expectations in the round of upcoming conference calls, and the market needs to hear a positive message for stocks to keep rallying. And though I'll be looking more closely at the key themes to listen for during earnings season in a forthcoming column, key highlights include:

• A more bullish view from U.S. multi-nationals as pent-up demand in Europe and elsewhere starts to get released.
• A still-dismal environment for U.S. consumer spending.
• More signs of renaissance for U.S. manufacturers as production is "insourced," or brought back to U.S. shores from other countries.

What does the full-year profit picture look like? Consensus forecasts anticipate that aggregate profits for firms in the S&P 500 will grow from $110 a share in 2013 to $119 in 2014 and $125 in 2015. That represents growth of 8%, and 5% respectively.
That slowdown shouldn't alarm you. Corporate profit growth often cools off in the middle phase of an economic expansion, as companies boost expenses to prepare for further growth. The key for stocks is for analysts not to get carried away and establish unrealistic profit expectations.

Pullbacks Ahead?
Even though the market has been moving higher for a seemingly long time, investors should still expect choppiness in the year ahead. For instance, Goldman Sachs' strategists apply a 67% chance of a pullback of 10% or more. We saw such moves in 2010, 2011 and 2012, with each double-digit pullback creating a nice buying opportunity.

However, note that those double-digit drops can play out in a very short time. The market always goes down faster than it goes up.

Risks to Consider: The risks to the U.S. economy are diminishing, but the U.S. has yet to tackle either its massive levels of government debt or a coming demographic surge that will lead to sharp hikes in entitlement spending.

Action to Take --> Investors have every reason to expect stock prices to climb higher in a few years. But after a stellar 2013, investors should prepare for bumps in the road, especially if the recent signs of economic growth reverse, interest rates rise too quickly, or companies deliver weak 2014 guidance in the coming earnings season. Pullbacks should be expected -- but they may also represent solid entry points for sidelined cash.

P.S. An eccentric Texas woman who dodged the 2008 financial collapse says the market is ripe for a pullback. This is the same analyst who's produced annual returns of up to 510% and has picked winning investments roughly 85% of the time. To learn how she's protecting her portfolio today, click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.