How the Stock Market Could Play out in 2013 and Beyond

When the market hit bottom in March 2009, investors needed to weigh two variables: The negative pull of a weak economy against the positive push of compelling low valuations. That push-and-pull dynamic has stayed in place throughout the ensuing years, as the market has offered clear bargains even with the U.S. economy remaining quite dicey.

#-ad_banner-#Yet as we turn the page into 2013, two new investing poles need to be assessed. On one hand, a number of individual stocks are still priced at reasonable levels (albeit not at the eye-popping levels we saw just a few years ago). On the other, the U.S. economy is starting to rumble to life, and though some headwinds will remain in place in 2013, it’s becoming increasingly evident the country will be growing stronger through 2014 and 2015.

But here’s the new conundrum for investors: Is this a time to get aggressive with stocks, looking past the near-term pressures of the fiscal cliff and focusing on a backdrop of potentially robust sales and profit growth as we head toward mid-decade? After all, there is a notion that “investors always look ahead” and an increasing number of bulls are seeing the recent spate of positive economic reports as a sign of better days ahead. 

Another camp argues that even as the fiscal cliff gets resolved with a short-term fix, law makers will still have to hammer out a longer-term deficit reduction plan during the course of 2013. And that will create a new set of concerns about economic growth and post-tax corporate profits. Let’s take a closer look at the bull and bear arguments.

The bullish case: The Seeds of growth are sewn
Considering all the headwinds in place, it’s quite impressive to witness signs of a strengthening U.S. economy. Consider the following data points.

• Home prices have risen 7% thus far in 2012, the best showing in seven years, and a sure sign that the housing sector has passed the worst phases of its crisis. If housing data stay firm in coming quarters, then a major housing construction cycle will likely kick in 12-18 months from now, which has positive spillover effects into many parts of the U.S. economy. Auto makers, for example, would sell a lot more high-margin pickup trucks that contractors use.

• Rising home prices also increase the financial sense of well-being among homeowners, who become more likely to spend once they take note of their rising net worth. That’s why retail stocks have traded up so well in 2012. A firmer consumer spending sector — which accounts for two-thirds of the economy — is a powerful catalyst for gross domestic product growth.

• Orders for durable goods in October (excluding autos and airplanes) were flat with September levels at $217 billion. A large number of companies predicted they would pull back on spending in the current quarter on concerns that the current fiscal cliff would derail the economy. If that’s the case, then many other companies stepped up spending to offset that weakness. When the fiscal cliff is finally addressed in coming weeks (and it surely will be), then the more cautious companies will join the fray and start making major capital spending moves in 2013.

• Why will companies spend more in 2013? Because they are sitting on mountains of cash, and they tend to invest when the economy looks set to be on firmer footing in 12-18 months, which now appears to be the case.

The bearish case: Roadblocks remain
Still, bears will likely continue to make the case that stocks won’t post major gains while Europe’s woes remain unresolved and the long-term U.S. government budget remains sharply out of balance. And when investors realize the economic drag that may ensue from a real budget fix, then the outlook for sales and profit growth may not be nearly as robust as some anticipate.

These bears will also tell you that stocks don’t seem like compelling bargains at the moment.

Let’s look at corporate profits and profit growth to get a sense of where we stand. Economists at Morgan Stanley recently updated their expectations for aggregated S&P 500 profits in 2013, and they predict that S&P 500 earnings will actually drop 1% in 2013 to $98.70 per share. The market currently trades for almost 14 times that figure, which is about right considering the tepid profit growth backdrop. 

Looking further out, a firming economy in 2014 should propel S&P 500 earnings about 12% higher to about $110 a share, according to Morgan Stanley. That puts the 2014 market price-to-earnings (P/E) ratio at about 12.6, right near that growth rate. Again, that’s nothing to get excited about.

Yet here’s the rub. Stocks can rally quite nicely in 2013 — regardless of topics such as 2013 corporate profit growth or budget discussions — if the U.S. economy continues to show signs that we are headed for a truly robust upturn in 2014 and beyond.

Risks to Consider: The biggest risk in the near term is a growing sense that Republicans and Democrats will fail to deliver an agreement by year’s end, and the fiscal cliff starts to take root in early 2013.

Action to Take –> After rising for much of the year, stocks have wobbled as the fourth quarter has progressed. That’s an indication of the bearish arguments taking stage alongside the bullish arguments. Yet the economic data points throughout this quarter have been reasonably impressive, which is why some bulls are starting to feel emboldened after this pullback.

In the near term, the fiscal cliff discussions could inject some fear into the markets — if the two sides remain at an impasse. Yet cliff-related weakness will uncover the values that longer-term bulls will covet, so the stage may be set for a solid upward move once the budget talks finally wrap up.

I would normally suggest a close monitoring of economic data in the weeks ahead, but Hurricane Sandy will likely skew the numbers, causing most investors to dismiss them as aberrant. Instead, you may want to keep a close eye on corporate profit warnings in coming weeks. If a large number of firms cite fourth-quarter weakness, then even the bulls may have to discount their outlook of an improving economy.

P.S. — It’s finally here… our Top 10 Stocks for 2013. Since we first began publishing this annual report in 2003, our picks have beaten the market 7 out of the past 9 years… including average annual gains of up to 38.7% in a single year. Go here to learn more.