Liquidity could support stocks next year

Citi analysts led by Tobias Levkovich highlight the fact that flows into stock mutual funds and ETFs have improved in 2013 relative to 2012. Stock mutual fund contributions and ETF issuance combined show almost $270 billion of inflows this year through the end of October after suffering $14 billion of outflows in 2012.

Some analysts predicted that a rotation from bond funds to stock funds will start in 2013, however, bond funds have only lost $40 billion in assets this year. In Citigroup Inc (NYSE:C)’s view, there is still cash on the sidelines as Americans have over $9 trillion of household deposits currently earning a real negative yield. Levkovich believes that most of the stock and ETF inflows have come from cash on the sidelines and not from bond fund outflows. For 2014, Citi analysts believe that investors will continue to deploy cash into stock funds and ETFs next year.

Equity flows Russell 2000

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Source: Citi Research

Earnings growth main driver next year

Citi analysts estimate 2014 S&P 500 (INDEXSP:.INX) EPS at $117.50 per share versus $110.10 per share this year, which reflects better economic growth and potential for EBIT margins to improve.  Levkovich notes that markets and EPS are highly positively correlated, as shown by the chart below. Thus, with better earnings in 2014 stock price appreciation could continue. 

S&P 500 Russell 2000

Source: Haver Analytics and Citi Research

Russell 2000, S&P 500 P/E gap approaches 7

For 2014 considering positioning and style is more important and Citi analysts are favoring large cap stocks and growth style. From the chart below, small caps are priced higher relative to large caps as the Russell P/E minus the S&P 500 (INDEXSP:.INX) P/E gap approaches 7. Also, given potential increases in volatility next year, as illustrated in the VIX versus yield curve chart, a less risky portfolio may make more sense. Furthermore, companies that are proactive in shrinking their share count do provide more wealth to shareholders and Citi analysts continue to invest in companies that engage in buy back activity annually.

Regarding sectors, Citi analysts favor technology firms, given that capital investment is increasing and that businesses may demand products produced by technology firms. Financial and utilities may also do well in 2014, in Citigroup Inc (NYSE:C)’s view.

Russell 2000 PE less S&P 500

S&P 500 Russell 2000

Overly optimistic expectations may drive higher volatility

During the next year, stocks may fluctuate as investors worry about tapering by the Federal Reserve, political debate over debt ceilings and budgets, and lower earnings guidance. Given the optimistic sentiment reflected this year, investors may become more negative triggering lower stock prices over the near term, according to Citi analysts.

Buckets of 5 for VIX s&p 500 fwd performance Russell 2000


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