Stock Watch


Midyear Investing Outlook, 2014

Anne Kates Smith

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



Whether or not a major pullback occurs, investors should expect continued shifts in winning styles and sectors. For example, the long winning streak of small-company stocks is likely coming to an end. From the market bottom in March 2009 until March 4 of this year, cumulative price gains for the small fry far outpaced their blue-chip brethren: 228% for the Russell 2000, a small-company index, compared with 178% for the S&P 500, more of a large-company barometer. But since its recent peak, the Russell 2000 has retreated 6%, while the S&P has been essentially flat. Historically, small-company stocks have led the market in periods of slower economic growth, but they fall behind when GDP grows by 3% or more, says Russell Investments, the keeper of the index. Moreover, small-company stocks recently traded at an average P/E that is nearly 110% of the 20-year average, while the P/E of large-company stocks was 6% below their 20-year average.

midyear valuations

Similarly, when economic growth lags, investors bid up the stocks of companies—of whatever size—that have rapidly growing earnings. So-called growth stocks have generally led the market since early 2007, an unusually long cycle of dominance. But with confidence in the economy improving, it makes sense to gravitate toward stocks selling at bargain levels relative to earnings and other traditional gauges of value. That means choosing shares of Caterpillar (CAT) over Tesla Motors (TSLA), International Business Machines (IBM) over Netflix (NFLX), and Merck (MRK) over Regeneron Pharmaceuticals (REGN). So far this year, iShares Russell 1000 Value (IWD), an ETF that focuses on large, undervalued companies, has gained 3.9%, while iShares Russell 1000 Growth ETF (IWF) has gained 1.1%. “Rotation is the lifeline of a bull market,” says veteran market analyst Ralph Acampora, of Altaira Ltd., a money-management firm based in Switzerland. “As long as the money goes somewhere else, but stays in the market, that’s fine.”

As you tweak your own portfolio, consider building some cash reserves. In a shifting market it doesn’t hurt to take some of the money you’ve made off the table to be able to pounce on new opportunities or if changes in your circumstances so dictate (see When Selling Makes Sense).

Sam Stewart, chairman of Wasatch Funds, has accumulated a little more cash than he normally holds in the funds that he manages as he prunes stocks he now considers overpriced from his portfolios. “Choppiness is a reasonable forecast for the year,” Stewart says. “I want to make sure we have some dry powder on hand in case the market does correct and we see companies we want to buy at attractive prices.” He says he will be looking for bargains among technology, health care and financial firms—particularly those that are lifting their dividends.

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Stewart currently recommends shares in CVS Caremark (CVS) because he believes the corner drugstore is becoming more central to family health care. Stewart also likes Wells Fargo & Co. (WFC), trading at a reasonable 12 times estimated year-ahead earnings and yielding 2.8%. The bank navigated the financial crisis “just fine,” he says.

Let’s just hope that investors will be able to say the same thing about navigating the stock market this year.

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