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As we approach the end of 2013, investors are in a joyous mood. The S&P is up better than 25% for the year and the NASDAQ has expanded by a third over 2012's closing levels. While there is much to celebrate around investment returns this year, investors should temper their outlook for 2014.

The forecast for 2014 is cloudy and not even the pundits with the most "rose colored" glasses expect a similar market performance next year. I am getting more cautious as we head into the New Year. Here are three of the critical questions that I think need to be answered for investors in 2014. The answers to these questions should greatly determine the direction of the market in the coming year.

When will the Federal Reserve start to "Taper" and what will be the impacts to the market?

Obviously this is the $64,000 question for most investors and fund managers. Much debate has taken place over the past few years over how much of the market rally has been due to the Federal Reserve's largesse. Every time Ben Bernanke has even mentioned the possibility of "tapering" the markets have had a volatile reaction.

We are finally going to get a chance to answer this critical question in 2014. While pundits speculate on when the Federal Reserve will start to withdraw the $85B of monthly liquidity the institution is currently supporting the market with, it is almost certain to start the process in the first half of 2014.

While the outcome of this event on the market is unknown, two things are fairly certain. Market volatility is going to go up in the first half of 2014 compared with the extreme stability of 2013. The bull market has gone a long time without a 10% correction, and the probability of this finally happening as the Fed starts to withdraw liquidity is highly probable in my opinion.

In addition, emerging markets are likely to be harder hit than our market when the taper does occur. I based this on to the emerging markets tanking in May when Chairman Bernanke started his taper talk. I would definitely underweight emerging markets going into 2014 because of this upcoming event.

Will Multiple Expansion Continue?

One of the worrying features of the rally over the last year is the rise was not correlated to earnings growth. The overall market is up a stellar ~30% over the past twelve months (See Chart).


(Click to enlarge)

However, earnings growth in the recently completed quarter looks like it will come in with a ~5% rise Y/Y. This number would be lower if it was not for the substantial amounts of stock repurchase activity as companies buy back stock instead of investing in growth opportunities. With margins for S&P companies at all times, where will future earnings growth come from in 2014? In addition, as interest rates rise due to the Federal Reserve tapering, financing costs should increase impacting margins.

I think a highly likely outcome in the new year will be the market will stagnate until if/when earnings growth catches up to the substantial capital appreciation of equities over the last year. This could be a best case scenario.

How bad will the implementation of the ACA impact the economy?

This is an "outside the box" question that I have not seen many pundits try to tackle. The Affordable Care Act (AKA, Obamacare) has been hotly debated in the press but mostly from a political angle as the initial roll-out of the program has been nothing short of disastrous.

I am more interested on the impacts to the economy, job growth and the markets. Before the employer mandate was push back one year on July 2nd, the impact to the job market was substantial and relatively uncommented on in the media. In the first six months of this year, net full time positions actually fell despite the unemployment rate falling. The reported job growth was solely caused by the rise of part time employment which rose by over 800,000 net positions in the first half of the year.

Obviously this has impacts to wage growth (part time jobs pay less than full time jobs) and consumer spending. As companies again begin their 3 to 12 month "look back" to determine their full time position count to comply with the new Jan 1st, 2015 employer mandate; I would look for job growth to again be dominated by part time jobs.

The other impact I see on consumer spending that has been overlooked is the substantial premium increases a good portion of the population is going to experience as the ACA gets fully implemented.

This has already occurred for individuals that had been self-insured and saw their policies cancelled as they no longer comply with the mandates of the ACA. As this program gets fully implemented, the next shoe to drop will be companies shifting more costs to employees or ending internal health care plans in favor of kicking their employees onto federal insurance exchanges.

I find it quite amazing that when gas prices go up 50 cents a gallon, financial commentators chime in with how consumers paying an extra $40 or $50 a month for gas will impact consumer spending. However, I have not seen many comments on how millions of individuals paying hundreds more a month for insurance will have any significant effects on consumer spending.

I think this story will have substantial legs in 2014. It is also a key reason I think investors need to be underweight the Consumer Discretionary sector. Retail sales for the just completed Thanksgiving weekend were down Y/Y for the first time in years which should be a worrying sign.

So where does this leave investors? In my opinion, I think 2014 will bring tepid returns from the stock market. I think a return of 0% to 5% with increased volatility is highly likely with a possibility of a substantial decline at some point during the year.

I would be underweight Emerging Markets, Consumer Discretionary as well as commodity based investments where the combination of higher rates and turmoil in emerging markets will be substantial headwinds. I would keep a decent amount of cash on hand ready to deploy if/when we get at least a 10% correction. I would also target equities that are priced at or less than the market multiple of ~16x forward earnings that should be able to substantially grow revenues & earnings above the tepid growth rates of the overall market. Here are two growth stocks I like for 2014 that are still selling at solid valuations.

I like eBay Inc. (EBAY) at current levels primarily because of its rapidly growing PayPal franchise. Mobile payments continue to see explosive growth. On "Cyber Monday" mobile transactions were up ~80% Y/Y and accounted for 18% of overall sales. Privately held Gilt experienced a 40% revenue increase Y/Y over holiday weekend and stated a majority of the sales for the period came from mobile devices.

EBAY just posted Cyber Monday revenue gains of ~32% Y/Y which was down slightly from the gains over the rest of the holiday weekend but still impressive growth. Smartphones will continue to expand their market share and with consumers getting increasingly comfortable with using mobile for more and more purchases, we are in the early innings of this growth. This transition will provide a long-term tailwind to market leading PayPal's growth. Overall, eBay is growing revenue in the mid-teens, yet the stock is priced at exactly at the market multiple. BUY

Regular readers know that I have been a bull on Apple (AAPL) for quite some time. The company continues to have momentum after recently breaking out of a narrow trading range. UBS just upgraded the shares lifting its price target to $650 a share from $540 previously. It also appears a distribution deal with China Mobile (CHL) and its over 700mm subscribers is imminent which will be another positive catalyst.

Earnings should grow more than 10% in FY2014 on a high single digit revenue increase. AAPL yields 2.3% and is returning ~$10B a quarter to investors via stock repurchases and dividend payouts. Subtracting the company's over ~$140B in cash and marketable securities, Apple sells for ~8x forward earnings; half the market multiple. BUY

Source: 3 Critical Questions For 2014