The march to record highs came despite hurdles that might have tripped up lesser bulls. First came a scare courtesy of hints that the Federal Reserve was about to remove the easy-money punchbowl that has kept this party going. That was followed by a government shutdown and then the threat of a U.S. debt default. What’s more, the stock market’s gains materialized despite a lackluster year for corporate profits, often considered the market’s main engine.
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So the phenomenal rally raises the question: Where is the market getting its strength? And more important, can this aging bull continue to run? Our answer: Don’t give up on the bull yet—it may be younger than it looks. “We don’t see a bear market coming,” says Henry Smith, chief investment officer of Haverford Trust. “We believe that March 2009 represented a generational low, and that this is the middle of a sustained bull market.”
Another year of gains will be supported by stronger economic and corporate underpinnings, and, just as important, improving sentiment among investors. By most measures, stocks are fairly priced, if not bargains. Given expected earnings growth of nearly 10% in 2014, we think stock prices could rise that much and perhaps more if investors again prove themselves willing to pay more for each dollar of corporate profits, ratcheting up the market’s price-earnings ratio. A reasonable range to expect would be 8% to 12% returns, including dividends. An 8% price gain would put the S&P 500 in the vicinity of 1,944, translating into roughly 17,300 on the Dow Jones industrial average; a 10% gain would put the S&P 500 at 1,980, the Dow a bit over 17,600. With dividends, the S&P’s returns could reach 12%.
Despite the wounds inflicted by squabbling lawmakers in Washington, the U.S. economy will continue to improve in 2014, with gross domestic product growing 2.6%, up from our estimate of 1.5% in 2013. For the first time since the Great Recession, consumers will see wages grow faster than inflation, with personal income rising at least 3.5% and inflation about 2%. Companies will continue to add to payrolls, with the unemployment rate fluctuating between 6.9% and 7.2% as more people decide to resume searching for work. To keep the economic wheels greased, the Fed will likely keep short-term interest rates near zero until 2015, but longer-term rates will rise as investors begin to anticipate an acceleration of economic growth. Look for the benchmark ten-year Treasury bond to end 2014 with a yield of 3.3%, up from 2.8% today.
Housing is a pocket of economic strength, with new-home sales expected to jump 16%. Outside the U.S., exports could rise by 4% as Europe’s economy convalesces and China’s slowdown levels out. Economists at IHS Global Insight expect global economic growth of 3.3% in 2014, up from an expected 2.4% in 2013. Among the challenges in the U.S. will be the fiscal uncertainty that bleeds into early 2014 as Congress wrangles with the level of government spending and with raising the debt ceiling (also known as giving Uncle Sam the wherewithal to pay his IOUs).
But the Federal Reserve holds the real wild card. Most Fed watchers expect the central bank to begin cutting back its massive, $85-billion-per-month bond-buying program in the first quarter. Last summer, the market swooned at mere rumors that the Fed was set to taper its stimulus. Dan Morris, global investment strategist for TIAA-CREF, notes that from the time the Fed’s two previous “quantitative easing” programs ended (in March 2010 and June 2011) until the next easing program was hinted at, the S&P 500 fell 9% and 12%, respectively. At taper time, “the markets will take fright, yields will go up, there’ll be volatility,” Morris says. “You could see a 10% correction, but people need to ride through it.”
The upside of fed tightening
That’s because tapering won’t commence until the economy is robust enough to withstand it. Recall the surprise when the Fed confounded market expectations by not tapering last September. The implication, says BMO Capital Markets strategist Brian Belski, is that tapering won’t begin until “there is incontrovertible evidence that the economy has reached escape velocity.” And you can expect much the same Fed policy to continue when Janet Yellen moves from board member to chairman early in 2014.
When it comes to corporate earnings, investors should focus less on absolute growth rates and more on the nature of the profits. After strong gains at the start of a recovery, it’s not unusual for earnings growth rates to flatten out. But a profit peak is still years away, says Christopher Hyzy, chief investment officer of U.S. Trust. Conspicuously missing from the profit picture in recent years has been a convincing pickup in revenues; instead, companies have engineered big chunks of profit gains through relentless cost-cutting. That could change in 2014 as consumer and business demand for goods and services finally picks up, and sales become a greater factor in driving profits. The period “is likely to be characterized as the dawn of a new business cycle,” Hyzy says.