What Not To Expect In 2014

2013 was a great year for equity investors no matter how you look at it. Returns were exciting – in a good way. And most U.S. indices hit new highs. In fact, 2013 was the best calendar year since 1997 for investors. Foreign and emerging markets did fair but not nearly as well as domestic markets. Bonds struggled in 2013. Let’s take a closer look and try to determine what might be in store for us in 2014.

The Economy

GDP expanded 2% in 2013 but it will likely grow at an even faster clip in 2014. The second half of 2013 delivered 3.4% annualized growth so we’re starting the year with some strong wind in our sails.

According to the ISM, U.S. manufacturing activity is strong and growing. New orders climbed to the best levels seen since 2010 and employment is the strongest it’s been for nearly two years.

Expectations are that American consumers (and the continued European recovery) will fuel our economic expansion. Durable goods orders jumped 3.5% in November which was more than twice the expected increase. That creates greater factory backlogs and that in turn leads to job creation. All of this is very good news.

It’s interesting that despite the government shut down and stimulus reductions, the economy and the market both did well in 2013. That’s because our economy is starting to gather steam and because of that, it’s reasonable to expect further stimulus reductions going forward.

This will be a huge positive for the economy and market over the long term but over the short term, nobody knows how the market will react.

More on Jobs

Employers haven’t been able to squeeze more productivity out of their existing staff so they’ve had to expand payrolls. New hires rose from 159,000 a month in the April-July period to about 204,000 a month over the last 4 months. The top economist for T.Rowe Price Alan Levenson sees unemployment dropping from 7% now to possibly 6% by year end. Of course this is good. Getting people back to work is the key to unleashing pent up demand

Corporate Spending.

Corporations are still sitting on a mountain of cash – over a trillion bucks as a matter of fact. Factory utilization is close to 80% and that’s the point where they usually start expanding their factories and hiring more people.

Buy Backs and Dividends

Corporate America spent a lot of money paying dividends and buying back its stock. Both of these tactics provide value to stock holders and tend to push stock prices up. Many pundits expect these buybacks to continue in 2014.

Another force that pushed prices up was a rotation out of bonds and into stocks. 2013 was the first time since 2006 that equity funds had positive net inflows. If that rotation into equities continues it could be a huge positive for the market.

Road Blocks Ahead

Despite all the good fundamental news, 2014 probably won’t be all strawberries and chocolate. I think there are a number of areas to be mindful of.

1. First, the Fed will slow down the stimulus as I said. And it’s possible that Federal bond purchases will completely disappear by summer 2014. I don’t think this is going to be a huge problem for the market given the direction of our economy but I can’t guarantee my crystal ball is going to be right.

2. Housing is something that demands our attention. Values rose 13.6% last year according to the Case-Shiller index and sales are at their all-time high. But mortgage demand is slowing as a result of interest rate increases. Builders expect slower growth but continued increases in home sales and prices. A strong housing market is a prerequisite to continued economic expansion. We’ll have to see how this plays out.

3.  As always, international conflicts continue to be a worry. Oil prices could spike on a Mideast flare up or a military event involving China and Japan. These contingencies are almost impossible to predict.

4. Most recoveries last 5 years. Our current expansion started in mid-2009 so historically this one is a little long in the tooth. It’s something to keep an eye on. On this point, many pundits don’t seem too concerned. Our domestic growth has been so anemic that the current positive business cycle could still be at its beginning. We’ll have to see.

My Concerns

At the start of 2013 I was very optimistic. This year I’m still optimistic but I’m cautious. While the economy seems to be very strong, there are a few data points that concern me.

First, if rates do go up, government borrowing costs will go up big time. If that happens, it will be harder for the government to function without seriously addressing the spending/revenue gap. If the future is anything like that past, that will lead to even more political gridlock and business uncertainty. That would hurt the market I believe.

Next, I’m concerned that very few people are concerned. This may sound counter-intuitive but when everyone is bullish, the market may find difficulties advancing. Optimism is very high right now. In fact, according to the Investor’s Business Daily, investors are the most optimistic they’ve been since 2007. I will certainly be monitoring this carefully.

Last, the market itself might be a little ahead of itself. 2012 and 2013 were both strong years. Historically, it’s hard to keep that kind of performance going.

Bottom Line

I believe that the strong positives that lay ahead create the foundation for a very good experience for long-term investors. What I don’t know is how the negatives I’ve shared with you might impact the market on a short-term basis.

My approach to this dilemma is to use a “market sensitive approach”. It doesn’t always beat the market and it certainly doesn’t immunize me from investment losses. But over the years, it’s worked for me. What do you think is in store for 2014? What are you doing differently with your investments?