Stock Watch


Midyear Investing Outlook, 2014

Anne Kates Smith

The bull market isn’t over. But expect a choppier ride.



Remember when you were younger, full of exuberance and able to jump higher and run faster? Was it only last year that a charging bull delivered a 32% return to investors in the U.S. stock market? The bull has matured and is now facing some of the setbacks of middle age. So far this year, Standard & Poor’s 500-stock index has returned just 3%. Still, we’re convinced that the bull market has got plenty of life left, so don’t give up on it yet.

See Also: Why Rising Interest Rates Won’t Kill the Bull Market

In our January issue, we predicted that the S&P 500 would finish the year in the vicinity of 1900, and the Dow Jones industrial average would close above 17,000. At midyear, we still think that’s a good, conservative bet, although it’s possible that stocks could tack on a little more—with the S&P closing between 1950 and 2000. That would produce gains of 6% for the year and would translate to roughly 17,500 for the Dow. Stock returns will mirror growth in corporate earnings, which analysts estimate at 6% to 7% this year. Dividends will add another two percentage points to the market’s return.

But the market has grown more complicated, with a lot going on beneath the surface. The tide is no longer lifting all boats—in order to prosper, you’ll have to be choosier about where you invest. Many of yesterday’s market leaders are becoming today’s laggards, making for choppier waters overall. In general, we think the rest of the year will favor larger companies over smaller ones; companies that sell at reasonable values over high-growth, high-priced stocks; and companies that are more sensitive to improvement in the economy than those considered more defensive. (For our take on fixed-income investing, see The Bond Rally Isn’t Over. For our international outlook, see Struggling Economies Mean Bargain-Priced Stocks. All prices and returns are as of April 30.)

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Five-plus years into the bull market, “2014 will be a big test,” says Matthew Berler, co-manager of the Osterweis Fund. Investors will grade the bull on how well it manages some midlife crises—or, if not crises, at least challenges.

Readying for higher rates

The bull’s first challenge will be making the transition from a market driven by super-easy monetary policies and little competition from fixed-income investments to one more focused on corporate profits. The Federal Reserve is unwinding its bond-buying program aimed at keeping long-term rates low and will eventually look toward raising short-term rates, most likely next year. As investors begin to anticipate that tightening, the market could suffer a 5% to 10% pullback, perhaps in the fourth quarter, says David Joy, chief market strategist at Ameriprise Financial (see How Bull Markets Meet Their Demise). But if raising interest rates to a more normal level is seen as a vote of confidence in the economy, as he suspects will be the case, then it won’t be the end of the bull market.

As for earnings growth, companies must become less dependent on the plump profit margins engineered by cost-cutting and other maneuvers and more reliant on revenue growth. “I’m cautious,” says John Toohey, who directs stock investments for USAA. “And my caution revolves around one theme: We need to see more revenue growth.” Since the financial crisis, per-share earnings growth has been strong as companies have cut costs, refinanced high-cost debt, lowered tax bills and bought back shares. A recent spike in mergers and buyouts is aimed at buying revenue growth, Toohey adds. But he and others would prefer to see more growth coming from actually selling more goods and services. “We’re a little surprised we haven’t seen it yet,” says Toohey.

Such growth will hinge on whether the economy can finally accelerate convincingly. Kiplinger’s expects gross domestic product to expand by 2.4% this year, up from 1.9% growth in 2013, with the growth rate picking up to 3% or better in the second half. Many of those who are optimistic about the economy and the stock market are pinning their hopes on another crucial transition—the one in which companies segue from stockpiling cash to spending it. “We’re five years out from the Great Recession,” says Joseph Quinlan, chief market strategist at U.S. Trust, Bank of America Private Wealth Management. “Companies have been hoarding cash. The next five years will be about deploying it.”



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