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Friday, February 7, 2014 - 14:30

Throw Out The Book On 2014 -- Here's What To Do Next

Friday, February 07, 2014 2:30 PM

Economics is known as "the dismal science" for good reason. Like the weather, economic winds can shift on a moment's notice, rendering recent forecasts completely moot.

But the current economy is proving to be even trickier than usual.

In the final months of 2013, the economy was developing a full-blown head of steam -- despite the impact of the October government shutdown. The U.S. economy grew at a 4.1% annual pace in the third quarter and a 3.2% clip in the fourth quarter. As the year began, all signs pointed to robust 3% growth in 2014, which would have been the strongest showing since 2005.

Quite suddenly, the U.S. economy is looking less perky. Since the start of the year, we've seen:

• Two straight months of non-farm payroll growth below 125,000, blunting the employment momentum we'd seen in prior months.

• U.S. exports fell 1.8% in December (data were released in early February) as global demand for our goods and services are starting to weaken. The key trouble spot: Exports to the

European Union fell 9% in December. And in the months ahead, demand coming from emerging markets may slump, especially in countries that have been hit by sliding currencies.

• Durable goods orders plunged 4.3% in December, and were revised lower for November.

• The housing market may be losing steam. An index that gauges the volume of contracts to buy existing homes slid in December to its lowest levels in two years, according to the National Association of Realtors.

• Auto sales slid 3.1% in January (from a year ago), according to Autodata.com.

Those last two factors could have been impacted by brutal weather, so it pays to track the housing and auto market in the next few months to see if the sales weakness is short-lived.

Some economists also cite the recent spate of bad weather for the economic reports. That might help explain auto or home sales, but other parts of the economy appear to be responding to other unseen headwinds, such as a stagnation in global trade.

The stock market's recent turmoil may also be creating some uncertainty among consumers. Only a late-week rally on Friday helped the S&P 500 Index avoid its fourth straight losing week.

The market's strong gains in recent years have created a powerful psychological boost, especially among upper-middle-income consumers. Spending by these folks has been one of the few bright areas of retail, and the U.S. economy can't afford to lose that pillar of strength.

Flickr/jurvetson
Dallas Fed President Richard Fisher, who will soon be a voting member on the Federal Open Market Committee, has repeatedly expressed concerns that continued stimulus could prove harmful to the economy.

When Bad Is Good
Friday's tepid employment report helped to send stocks higher, as investors concluded that the Federal Reserve may look to slow the pace of tapering in its stimulus program.

Though it's unclear whether the Fed will actually change its policy, investors should not be greeting this as good news. Dallas Fed President Richard Fisher, who will soon be a voting member on the Federal Open Market Committee (FOMC), has repeatedly expressed concerns that continued stimulus could prove harmful to the economy.

Let's assume for now that the Fed will continue to shrink the size of its monthly bond buying. And let's also assume that the economy is not quite as weak as the recent data suggest, yet not as strong as the economic data were suggesting just a few months ago.

If that's the case, what should investors expect from the market? A tug of war between bulls and bears that leaves the market stuck in a trading range.

Bulls Vs. Bears
Bulls will argue that valuations are not overly stretched and that massive share buybacks will continue to fuel EPS (earnings per share) gains, even if sales growth is anemic. The recent pullback in interest rates (the yield on the 10-year Treasury has fallen from 3% at the start of the year to a recent 2.75%) again creates a backdrop where equities are the only game in town for income-seekers.

Bears have a different view: They believe the five-year bull market has largely played out and that sales growth among S&P 500 companies (many of which have a high level of exposure to troubled foreign markets) is going to be very modest in 2014. For companies that are counting on the U.S. to pick up the slack, consumers remain under deep duress.

In a Feb. 4 note to clients, BlackRock investment strategist Russ Koesterich noted that "while consumer spending is still rising, that spending is coming from savings rather than from increases in wages and income -- an unsustainable trend. Unless the pace of wage growth accelerates, spending will eventually slow, which would act as a drag on the broader economy."

If consumers remain on the sidelines, then U.S. economic growth will have to come from an uptick in capital spending by companies. Yet such spending decisions are pegged off of economic confidence, and if the economy continues to generate weak data points, then companies may start to slash their capital spending budgets.

Risks to Consider: If investors come to believe that the Fed will not be deterred from its path a reduction in bond buying, investors may look to sell stocks on fears that the lack of stimulus will slow the economy.

Action to Take --> We simply don't know where this economy is headed. The recent trouble signs may prove to be short-lived, and this economy appears capable of shifting course on a dime.

For investors, that makes this a risky time to remain firmly in the bullish camp. Instead, view this as a stock-picker's market, focusing on companies that are likely to be insulated from economic headwinds and still trade at reasonable valuations. Said another way, this is not a time to be buying richly priced momentum stocks. When the economy cools off, stocks with high P/E (price-to-earnings) ratios are often the first to be sold.

Lastly, the market is in the midst of an unusual trading pattern, as rapid plunges are followed by robust rebounds. A wide range of high-beta stocks have fallen by double digits in just a few days, only to rebound by a commensurate amount. That volatility makes this a good time to be a trader rather than investor.

P.S. I just finished reading a special report by my colleague, Amber Hestla-Barnhart, about how investors can consistently and reliably pull income from the options market. And you don't have to be a sophisticated trader to do it. Go here to learn more.

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.