We finished up 2013 on a strong note, with all three markets finished up for the year.
Wall Street was getting nervous during the end of the year partly because tapering was becoming more imminent and partly because the S&P 500 had been on an impressive run without a 10% correction for a long time. Two years, to be exact.
The last correction was October 2011, and the S&P 500 is up nearly 60% since then. Believe it or not, that’s not as unusual as it seems. In the 1990s, the index went seven years without a 10% correction, and in the first decade of this century, it enjoyed a similar stretch for four-and-a-half years from March 2003 to October 2007.
What we are seeing are rotational corrections under the surface, as money flows from one type of stock to another. One element of this is the flight to quality that’s benefitting us. I don’t see a major correction as very likely because of all the money flowing into the stock market. I wouldn’t be surprised to see some bumpiness around mid-February as the fourth-quarter earnings announcement season winds down but any such pullback should be viewed as a good buying opportunity.
I say that because 2014 looks very promising. There are a variety of reasons:
It’s nice to welcome back an old friend! Earnings growth among S&P 500 companies was essentially nonexistent for five straight quarters, but it finally materialized in the third quarter. Best of all, growth is expected to accelerate in the fourth quarter and then every single quarter in 2014. Stocks were able to move higher even without earnings growth thanks to the Fed’s money pump, and it’s important that growth is returning around the same time that the Fed is starting to cut back its stimulus.
Earnings should pick up with a strengthening economy, and I’m also encouraged that the U.S. dollar has weakened to its lowest level in almost a year. This helps multinational companies because they get paid in other currencies that are stronger relative to the dollar.
A Stronger Economy
It’s clear that economic news has improved, starting with the big upward revision in third-quarter growth to 4.1% from 3.6%. That was the best in two years, and was well ahead of expectations of 3.6%. Also, the latest ISM manufacturing index hit its highest level since April 2011, and there is evidence of a worldwide manufacturing boom thanks to strong demand from Asia, Europe, the Middle East and U.S.
Consumers account for about two-thirds of the U.S. economy, so it’s good to see spending has been heating up this holiday season. Consumer spending is improving partly because household net worth has increased along with rising stock prices and real estate values. Confidence in the job market also plays a big role, so it helps that job creation is picking up. Clearly, the Fed’s quantitative easing is causing a “wealth effect” that should help create jobs and boost overall economic growth.
A Still Accommodative Fed
The question of when the Fed would “taper” has been weighing on investors for a long time. Not anymore. Now we know it will happen in January. I thought they might do it a few months later, but it doesn’t really matter. What matters is that this is a mild cutback. I was looking for an $8 billion to $10 billion reduction, and the Fed went with $10 billion.
I believe the Fed won’t cut too aggressively too soon because despite overall improvement in the labor market, problem areas remain. The unemployment rate for workers 25–34 actually rose in November (to 7.4% from 7.3%), and the rate for 20–24 year olds was 11.6%. That’s an improvement from 12.5% in October, but youth unemployment remains shockingly high. Incoming Chairperson Janet Yellen takes the Fed’s unemployment mandate very seriously, so I expect her to be cautious in unwinding support for the economy. And even with a cutback in QE, the Fed will remain accommodative on interest rates, which should remain historically low.
Rising Bond Yields
Rates moved up after Chairman Ben Bernanke said earlier this year that tapering could come at any time, and rising Treasury bond yields are another positive factor driving stocks higher. As the price to buy a bond falls, the yield rises because you’re getting the same interest rate payout but at a cheaper cost.
Rising yields mean falling bond prices, and that makes fixed income investors more nervous because the principal of their bonds erodes. This is especially problematic for bond mutual funds because investors cash out due to the principal erosion. As they flee bond mutual funds, they have to put that money somewhere, and historically it migrates to stocks. With the market still yielding more than banks and the Fed maintaining its 0% interest-rate policy, there is nowhere else to go.
So I expect 2013 success to carry into 2014, especially the first part of the year. January is typically a strong month because a new wave of pension funding floods the market, and this year, fourth-quarter earnings should be significantly better than the third quarter. It’s also nice that we shouldn’t have to worry about another possible government shutdown early in the New Year.
Looking further down the road, I do expect the market to get a little bumpier after April 15, because that’s when pension funding winds down. The good news is that this should be somewhat offset by good earnings. Still, at the end of nearly every quarterly earnings season there’s usually profit-taking. We may see it in mid-February for a few weeks, in mid-May for a few weeks, in August and again in November. It’s perfectly natural for some of our stocks to consolidate at the end of earnings season.
Bottom line: I expect the stock market to continue to “melt up” on persistent stock buybacks, strong inflows, a strengthening economy, more robust earnings growth and a still-accommodative Fed, 2014 has the potential to be as good as or even better than the strong 2013.