No matter how you slice it, 2013 was a terrific year for stock investors. The +32% return for the S&P 500 was the third best showing since 1970. However, this success breeds two very different responses from investors as they look out at the new year.
1) Elation that the good times will continue.
2) Fear that it has been too good and now we are due for a fall.
In this article I will review the investment landscape for the year ahead. This will include a target price for the S&P 500 along with some potential pitfalls.
The statistics below should tell you a clear story that there is no benefit or harm the year following a big rally year like we had in 2013. Simply it states that each year is unique and will move up or down based upon the factors going on at that time.
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So What Are the Unique Factors in 2014?
The economic picture continues to improve as GDP growth is accelerating from the previous Muddle Through pace of just 1-2% growth. So right now there is no threat of a recession, which is Public Enemy #1 for stocks.
The main issue at this stage revolves around valuation. Those who point to a historical average PE of 15 say the market is fully valued at this time given expected S&P 500 earnings per share of $120 this year.
This is a short-sighted view. First, that 15 average PE concept goes back too far in time when investors did not properly appreciate the risk/reward relationship of stocks versus bonds. Since then 16-17 PE has been more the norm.
Second, a maturing bull market will always have higher valuations than average. That is the difference between fair value and fully valued.
Third, valuation is also about the attractiveness of stocks versus other investment alternatives. Cash continues to be trash with ultra-low interest rates. Bond funds are losing money as rates go higher. Real estate has stalled out (also thanks to higher rates). Gold is going nowhere. And please let’s not waste our time talking about bitcoins.
Add it all up and this points to another year of gains for stocks.
2014 Prediction & Potential Pitfalls
The S&P is up 53% the past two years and +177% since March 2009. Thus, the easy money has been made and we should not expect such robust returns in 2014.
More likely stocks will provide a more modest gain of +8 to 10%. That would create a target range of 2000 to 2040 on the S&P, which is a fully valued market around 17 times current year earnings estimates.
What would prevent this from happening?
Three hazards are out there:
1) Recession: Above I shared with you that the economic landscape is actually improving. However, the average expansion period between recessions lasts for 63 months. If that held true here we would see the next recession starting in the 2nd half of 2014.
Gladly this does not happen like clockwork. Each expansion is unique and this one seems to have plenty of life left in it. Yet, if the next contraction does start to appear, then the route to profits is by shorting the market.
2) Treasury Bond Rates: There is a historical relationship between Treasury bonds and the stock market. And that would be an Earnings Yield that is 3% above the Treasury 10 year rate. Right now that rate is 3% + 3% premium for stocks = 6% Earnings Yield. This implies a PE of 16.7 is fair value for stocks.
I believe stocks will do fine if rates float up to around 3.5%. Above that and it will start to call into question their relative value versus bonds, which could spark a correction.
3) Volatility: The gains in 2013 came all too easily. Each correction was shallow and short lived. I suspect we will see a bit more volatility in 2014 and those that spend too much effort timing the market will likely get chopped to pieces. Likely it will prove best to just stay the course with the best long positions and don’t sweat the temporary downturns that come our way.
What to Do Next?
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Steve is the Executive VP in charge of Zacks.com and all of its subscription services. His personal mission is to help investors achieve life-changing investment success by harnessing the power of earnings estimate revisions. Over the years, he has developed a full array of services to help investors do just that. Discover all of these services now to find the ones that perfectly fit your investment style. Learn more about Zacks Ultimate.