While we probably won’t see any surprises bigger than the one we saw in 2013, with the S&P 500 being up close to 30%, there are sure to be unforeseen events in 2014. I’m not sure anyone saw 30% coming with the headwinds we faced at the beginning of the year when we went through a tax hike, a sequestration that dragged on GDP, arguing about the fiscal cliff and risking default on our debt service, possible war in the Middle East and finally a government shutdown. One would think after reading all that, the stock market wouldn’t have been so kind all year long. However, we never even saw a full-blown correction of 10% or more, but that will happen at some point. So, while 2013 was pretty much a smooth ride there are bound to be some surprises in the new year that aren’t priced into share prices already.
Tapering Happens Too Quickly
When the Fed decided to slightly trim back its QE3 program by $10 billion a month, I called that the market was ready and wouldn’t sell-off and I said the $10 billion figure was more symbolic than anything else. I still believe the Fed wanted to taper slightly to see how markets reacted. The reaction was one of jubilation as all major indexes were up more than 1% that day which is bullish as it meant market participants took the news to mean the Fed thought the economy was strong enough to handle it. But unemployment also fell more than expected to 7% and GDP growth was raised to 4.2%. Might this give the Fed the ammunition it needs to really begin tapering in a meaningful way? I believe it could. I also believe a large taper isn’t priced into the market and any surprise from the Fed could cause the market to correct steeply.
Fed Tightening: A Good Idea
A full tapering probably won’t occur until the trend in economic data continues on its upward trajectory. You can probably expect the same, data-dependent decision to continue under the new Fed chair Janet Yellen. While it’s true, earnings growth is due more to cost-cutting measures by large companies, this year could surprise people. After strong gains at the start of a recovery, it is absolutely normal for earnings growth to move sideways for a while until the 2nd half of the recovery begins. I believe 2014 should be the start of the 2nd half of the recovery while consumer and business demand for goods and services finally picks up and sales become a greater factor in driving profits. The period could be characterized as the dawn of a new business cycle. Personally, I think we’re in the same cycle we’ve been in since 2009, it just sometimes can seem so volatile that it appears we’ve gone through 3 or 4 cycles. I expect GDP and earnings growth to pick up the pace in 2014 and with them, share prices. I’d be surprised to see another 29% from the S&P 500, but we should see a nicely positive year.
Too Much Happiness
You’d be hard-pressed to find a deluge of positive economic news coming out of the media, but with recent strong data coming in on GDP growth, earnings growth, housing, and unemployment, some pundits and analysts are getting ready for their New Year’s Eve parties and happily ringing in 2014 as the “Year of the Boom.” A quick Google search seems to indicate that there are more bulls right now than bears and some of those bulls are downright giddy. This begs the question: Are we in a stage of Euphoria? Euphoria is bad, bad thing for stocks because it means everyone is getting in on the action, driving up share prices way past what their valuations suggest, and eventually there is no one left to buy and nowhere for prices to go but down. However, I don’t see Euphoria yet. First of all, the media is an important component of Euphoria. When the headlines start getting bullish, be careful. Also, valuations are about where they should be and should continue to look better as the economic recovery continues. Additionally, there is too much cash on the sidelines right now, trillions in fact. Bear markets usually don’t occur when this is the case.
As with any year, 2014 could be the year of some major conflict. Think back to when Russia invaded Georgia or any time Israel gets involved with anyone of it’s neighbors, this usually sends the stock market down for some period of time. This year we could potentially see problems coming out of South Africa. Their currency is in deep decline, they have growing budget and trade deficits and slowing growth. It’s very possible the rating agencies could downgrade South Africa causing foreign money to flee, which would then in turn cause a full-blown financial crisis that could spread to other emerging markets.
The Eurozone’s Problems Europe will not be without its problems either. Yes, it has come out of recession led by the UK, which has had sustained economic growth since they ended QE. The real problem in Europe might be the European Union itself. It looks like many parties hostile to the EU itself may gain control in Parliament. The UK Independence Party, the National Front in France, Alternative for Deutschland in Germany, and the Freedom Party in Holland could form a majority. They can throw out the budget block legislation and veto appointments. Due to this, the EU could find itself in a constitutional crisis.
Putting it All Together Almost every calendar year brings with it shocks that could temporarily cause the market to correct or even reach full-blown bear market territory. Some things are just unforeseeable. But even with the problems that could arise, I’m still very optimistic for 2014. Growth should pick up, which in turn should help earnings, unemployment and stocks prices. We have too many tail winds for 2014 not to be another good year in the economy and stock market. Yes, there will probably be surprises along the way and we could see that correction that never came in 2013, but our economy is strong enough to handle some relatively small events. Remember, investing is always going to be two steps forward and one step back. We took a few steps forward in 2013 so expect more volatility but ultimately, when it’s all said and done, we should be ringing in a happy new year next year as well.
by Mitch Zacks, Senior Portfolio Manager. Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A in Analytic Finance from the University of Chicago.
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