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Investing

Will Stocks Keep Rising?

There's no sign that Washington gridlock will abate. But the economy and the stock market may do well anyway.

The fiscal cliff is history. But the partisan paralysis in Washington will almost certainly continue throughout the year -- and that creates a huge headwind for the economy. Still, I think there's a good chance that the economy will continue to grow steadily, though slowly, in 2013 and that the stock market will deliver respectable gains.

Let's start with the bad news. Forget about a "grand bargain" to solve the debt crisis. House Republicans will continue to fight tax increases on the wealthy and insist on spending cuts, particularly in Medicare and Medicaid. Democrats will remain just as stubborn in opposition. Expect more havoc.

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The next fight is already upon us. Washington will be consumed by President Obama's efforts to raise the debt ceiling, which House Republicans have seized on as their next opportunity to try to cut spending. What's more, the fiscal cliff bill that Congress passed on New Year's Day delays $110 billion in automatic spending cuts for only two months.

Next fall will likely bring another stalemate -- this one over the federal budget for the year that ends September 30, 2014. Howard Gleckman, of the non-partisan Tax Policy Center , writes that "2013 may be the year of perpetual fiscal policy crisis."

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The debt crisis is serious. But with the economy still fragile, this isn't the right time to cut spending. Measures to address the deficit, including a mix of spending cuts and tax hikes, over the coming ten years would reassure the markets. But what we need today is more federal spending to stimulate growth. That, however, is something Congress is unlikely to approve.

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No one in Washington is even talking about additional stimulus -- except Federal Reserve Chairman Ben Bernanke, who, thankfully, is doing everything he can to boost economic growth. The Fed's tools, unfortunately, are blunt instruments.

Still, I'm moderately optimistic about the economy. Unemployment is declining, albeit much too slowly. The housing market is finally recovering. Animal spirits seem to be slowly awakening among corporate chieftains and investors alike. "The underlying trend in growth does not appear to be deteriorating," Jim O'Sullivan, chief U.S. economist for High Frequency Economics, said in a recent note to clients. He sees real gross domestic product rising 2.5% to 3% in 2013, up from an estimated 2.1% in 2012.

O'Sullivan is more upbeat than most economists. Alan Levenson, chief economist at T. Rowe Price, sees 2.25% GDP growth in 2013 and little chance of recession. Standard & Poor's predicts 2.3% growth. (Kiplinger's forecasts a 2.0% rise in GDP.)

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When I want to know how the stock market will do, I often head first to a top-notch bond-fund manager. That's because bond managers have to get the big picture right to succeed.

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After a long career at Loomis Sayles Bond, Kathleen Gaffney recently joined Eaton Vance, where she's in charge of a multisector bond fund the firm will launch this month.

Gaffney is upbeat about the U.S. economy and bonds that behave like stocks, such as convertible securities and low-rated "junk" bonds. "I think growth will increase in 2013, and the U.S. will stand out as the best place to be in the global economy," she says.

But high-quality bonds and the better class of junk bonds (those rated double-B) "are an accident waiting to happen," she warns. "There's very little upside and lots of downside for higher-quality bonds." What's more, "When money comes out of the bond market, it will come out very fast," boosting yields, which move in the opposite direction of prices.

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Europe, she says, will probably take a year or two to emerge from recession. Nevertheless, she's finding value in some of the "peripheral European" bonds -- bonds in countries such as Ireland and Italy, which triggered the seemingly never-ending euro-zone crisis.

Emerging markets will have to cope successfully with inflation to do well this year, Gaffney says. She thinks some emerging markets have the political will and policy tools to handle inflation, and others don't. "We'll see the wheat separate from the chaff."

The stock market has essentially made an enormous round-trip in the past five years. For the five years through 2012, Standard & Poor's 500-stock index returned a meager annualized 1.7%. At the same time, the bull market that began March 9, 2009, is now almost four years old, and some worry that it's time for stocks to take a breather.

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If the market heads south in 2013, though, it won't be because valuations are wildly out of whack. As of January 8, the S&P 500 index traded at 17 times reported earnings for the four quarters ended September 30. That's precisely the long-term average price-earnings ratio of 17. If the economy continues to recover, corporate profits will continue to rise. Indeed, the S&P 500 trades at just 13 times analysts' estimated earnings for 2013.

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What's more, large companies, and, particularly large, relatively fast-growing companies, aren't commanding their usual premium P/E ratios in comparison with small-company stocks. That's why I keep arguing for overemphasizing big blue chips.

As you'd expect, stocks in foreign developed countries are cheaper than U.S. stocks. Europe and Japan face huge economic challenges. But the P/E of the MSCI EAFE index, which tracks stocks in developed markets, is just 12. So, don't ignore foreign stocks; they're cheap.

To me, the real bargain -- aside from the aforementioned high-quality U.S. stocks -- is emerging markets. The MSCI Emerging Markets index trades at a P/E of only 10. Emerging markets are volatile, but they offer good value now, as well as good long-term growth prospects.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

Kiplinger's Investing for Income will help you maximize your cash yield under any economic conditions. Subscribe now!

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