Cold Comfort

Last month I attended a forecast luncheon at the New York Society of Securities Analysts for strategists’ evaluation of this year’s investment landscape.  Coming off a stellar 2013 for equity investors, the mood was generally upbeat, albeit tempered for 2014.  Here are some of the most interesting points:

“We are due for a correction” – or, beware of the VIX!

Each strategist noted that the market was overdue for a 10% or greater retreat after an almost uninterrupted climb throughout 2013.  While extreme stock market gyrations feel unpleasant, they are a necessary part of the risk/reward paradigm whereby reward is commensurate with risk and time invested.  This year, the S&P 500 index is down around -5% and the VIX index, a measure of stock market volatility based on the options market, has increased about 37% over last year.  So is this IT, the great correction?

While too soon to tell if this is the overdue correction, several catalysts are in place for a steep decline. It is the quarterly earnings season, when companies are reporting their 2013 profits – always a jittery time.  Sam Stovall, strategist for Standard & Poor’s, notes that “There’s no time like the second quarter” based on his study of historical stock market performance and the seasonality of fund inflows.

Valuations become more important this year 

Last year much of the gains in stock market performance came from investors bidding up the value of stocks rather than from increased company earnings.  The overall earnings multiple became more expensive from about 13 times price to earnings (P/E) to more than 17 times earnings.  In other words, the “P” in price increased while the “E” remained stable in the ratio.  While there is some disagreement about the right level of the P/E ratio in a low inflationary environment (some strategists argued for higher levels around 20 plus, similar to the 90s), stocks currently appear to be about the right price until earnings increase significantly.  Look for earnings of individual companies to be under greater scrutiny in 2014. 

Policy and government influences

On the plus side for investors, fiscal drag from deficit spending is becoming less of a burden on economic growth with Congressional Budget Office deficit estimates at 3% this year and 2.6% in 2015.  However, a political showdown over the debt ceiling late February/early March may roil markets as Republicans demand concessions from Democrats in exchange for authorizing an increase.  Additionally, 2014 is a midterm election year, historically a time for market retrenchment.  Also part of the mix is a new chair of the Federal Reserve, Janet Yellen.  If bond buying by the Fed does not match investor expectations, selling could ensue.  Note: I would regard a correction as a buying opportunity based on the advance since the last time taper fears hit the market and rebounding corporate profits.  See Taper, taper toil and trouble

Better than cold comfort – history is on the side of the investor

As one strategist noted, “good years often follow great years”.  Moreover, it has been almost five years since the S&P 500 hit bottom on March 9, 2009 during the global financial crisis.  Economic growth, while not as robust as other recoveries from recession, has been slow and steady with estimates for 2014 at around 3%, better than last year.  During the recovery from recession, American companies have been restructuring and are now sitting on piles of cash.  Some advantages for  the strongest economy in the developed world are:

• The US is leading the world out of a global recession
• Lower input costs will lead to higher profits
• Manufacturing has rebounded due to lower energy costs, greater productivity, and some “on-shoring” of facilities from overseas

Investable Themes 

1. After years of sitting on their cash, strategists say that companies will initiate capital expenditures, which should benefit companies in the Technology sector.
2. Small and medium companies, whose earnings tend to be 90% domestic (versus 50% for multinationals who are exposed to the slowdown abroad) should benefit from a growing US economy
3. Sectors that remain under pressure include Commodities and Energy due to tepid growth in China, emerging markets and Europe.