The stock market in 2014: up, but volatile

In the short term, markets move on current sentiment; longer term, they move on fundamentals

The global equity market had a resounding year in 2013, led by the U.S. stock market returning 30 percent (the market’s best year since 1997) and foreign equities up some 18 percent.

In the short term, markets move on current sentiment; longer term, they move more on fundamentals. During the past several years, the U.S. economic growth rate has been relatively sluggish — of late, however, the trend line has been accelerating upward. In addition, Europe is coming out of recession. Emerging market growth has slowed, and in the near-term will remain subdued, but longer term will outperform their more developed markets.

The stock market is one of the best leading indicators of the future direction of the economy, which is why it can be going up, as it did in 2013, at a double-digit-clip even though it felt somewhat stagnant. Typically, the equity market leads by some six to 12 months; key indicators are now telling us the economy is starting to grow more robustly.

As for 2014, we remain confident in another positive year for stocks. Historical trends support this view. Birinyi Associates recently showed that in 23 of the last 85 years, the S&P 500 grew by 20 percent or more. The following year, the market averaged growth of 6.4 percent. Other analysts show that 70 percent of the time the market rises, as it did in 2013, a positive market emerges the following year.

How high up in 2014? It’s a tough call, as many variables weigh in, not the least of which is Washington grandstanding. But the most pronounced factor is corporate earnings growth – earnings drive share prices. U.S. corporate earnings grew some 11 percent in 2013. The trend line is for increased earnings, but of late, the growth rate has been slowing. We see earnings growing more along the lines of 8 percent in 2014.

Factoring in current and projected P/E ratios and current market dynamics, the S&P 500 should end the year up by between 9 and 13 percent.

Making a call like this is tough because earnings in 2014 will also be determined by continued economic expansion, which we see, but the rate of pickup is difficult to pinpoint. The last few years, GDP has come in about 2 percent. We see that trend line going higher this year, north of 2.5 percent. Global GDP growth will be even higher, likely at a rate of 3.5 percent. If the U.S. GDP growth goes beyond 3 percent — a rate the job market is not now telecasting — the market once again could show double-digit returns.

Noticeable improvement

We also see the likelihood of a significant correction at least once during the next six months, probably exceeding 10 percent.

It is likely money will flow into the market during the first quarter, pushing up the gains achieved in 2013. The flow will be uneven, as many will be saying the market is overvalued, causing investor skittishness as the year progresses.

It will be a noticeable improvement in the economy that will accelerate Fed bond tapering, setting the stage for longer-term bond yields to again move higher. This means the bond market will continue its bearish trend, but the impact may not be as pronounced as many predict, if only because there is no inflation or wage pressure. But the general direction is upward, with the 10-year Treasury getting to the 4 percent range in 2015.

Inflation is nowhere evident on the horizon and likely won’t be until the labor market heats up, and there is no indication that will happen anytime soon. In fact, even though the unemployment rate is 7 percent, the real jobless rate is probably in the range of 12 to 15 percent, and the labor participation rate is at historic lows.

Oil and gas prices are steady and trending downward. That said, if the economy heats up more than the current trend line, energy prices will follow suit.

The REIT market (real estate investment trusts) got hit in 2013, breaking a long-term winning streak, but in our estimation such an asset class should remain part of most portfolios because of the likelihood of increased real estate rents or lease prices, offsetting some of the interest rate risk inherent with such instruments.

In terms of market and industry sector weightings, in very general terms, an improving economy should result in outperformance in such sectors as industrial and capital goods (manufacturing picking up), technology (companies replenishing aging equipment) and consumer discretionary (the consumer feeling more willing to spend in an improving economy).

I will leave you with a recent statement by Warren Buffett that speaks directly about investing: “It’s a terrible mistake to try and dance in and out of it (the stock market) based upon the turn of tarot cards, the predictions of ‘experts,’ or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.”

Mark Connolly, principal of New Castle Investment Advisors, LLC, Portsmouth, is a former director of the state Bureau of Securities Regulation. He can be reached through newcastleinvestments.com. A more in-depth analysis can be found at http://www.newcastleinvestments.com/outlook.html.