The exceptional market year of 2013 is winding down and all but the most die-hard bears are sad to see it go. Even amid uncommonly bitter partisanship in Washington and a host of other policy and economic issues, the market sailed blithely through every storm, rarely retracing more than a few percentage points and using every dip to push to new highs.
Such strong market years do not always precede follow-on rally years -- and we are concerned as we hear even dyed-in-the-wool bears offer bullish guidance for 2014. Still, with economic fundamentals intact, corporate earnings still growing and valuations attractive, we look for an additional low-double digit stock market gain in 2014.
Wall of Worry? Thank you, Washington and the Bond Market
It's been said that the bull needs a wall of worry to climb, and bifurcated Washington has obliged through nearly the entire rally since early spring 2009 (but particularly in the past two years). In October 2013, the partisan divide reached new heights of pettiness and irrationality, leading to the two-week government shutdown. In mid-2013, the stock market also confronted the first substantive change in the direction of interest rates since 2002 (arguably, the downtrend in rates has been in place since 1994 or even 1981). Yet even with the Fed moving from taper talk to taper reality in December, the stock market continued to push higher. As we went to press, the S&P 500 was less than one point below all-time highs.
Following the bitterly contested presidential election and the fiscal cliff resolution at the very end of 2012, the market rallied into the early months of 2013. Stocks enjoyed an unbroken run higher through mid-May, when the directional change in long yields became evident. The 10-year yield moved from 1.62% on 5/2/13 to 2.23% on 6/12/12, for a trough-to-peak move of more than 34% in little more than a month. The long yield reached 2.98% on 9/5/13 even though the market was only at phase one (Pundit Taper Talk) of a three-stage process that also includes phase two (Fed Taper Planning) and phase three (Fed Taper Enactment).
Although the first phase of taper-talk unhinged the bond market, the stock market merely wobbled before righting itself. After weakening across late May and most of June, the index rallied to new all-time highs by late July. Other stock market pullbacks -- related to normal seasonally soft data (in August) and in response to the government shutdown (in mid-September through mid-October) -- turned out to be buyable dips, once again leading to new market highs.
The September peak in yields was supposed to correspond with the first tapering, according to the consensus of economists at the time. Yet the bond market's severe reaction, along with some tepid economic data at the time, appeared to sap the Fed's resolve to enact tapering in the autumn. At the very least, the surge in mortgage rates and the related (and unfounded) fear that the housing recovery was at risk gave a cowardly Fed all the cover it needed to defer the first, tiny tapering until the very end of the year.
The Stock Year: Solid, Smooth, Placid, and Broad
How solid was the stock market year? After the nearly unbroken run higher to mid-May, when the first whispers of tapering stalled the rally, the market finally reversed in mid-June. Yet despite signs that the direction in bond prices was breaking a decade-long or even multi-decade-long trend, the S&P 500's peak-to-trough decline from 1,669 on 5/21/13 to 1,573 on 6/24/13 was 5.6%. Barring some last-minute catastrophe, the late-June reversal will stand as the worst pullback of the year. The other two notable declines this year were a tame 4.6% pullback into late August, and the 4.1% fallback by early October as Washington remained shuttered. Bargain bulls waded in after each dip and quickly sent the market to new heights.
How smooth was the stock market year? On November 19, 2012, the S&P 500 climbed back above its 200-day trendline after a brief (three-session) sojourn below. Right ahead of the end of 2012, as fiscal-cliff partisanship reached its zenith (or nadir if you're a cynic), the index level nearly hit its 200-day trendline, but avoided it on the bipartisan settlement. In 2013 to-date, the S&P 500 never breached its 200-day trendline; indeed, it never came close. During that taper-fear selloff in late June, the S&P 500 index price pierced its 20-day and 50-day trendlines. But even at the late-June low of 1,573, the index remained nearly 70 points, or 4.3%, above its 200-day line. And even at the third low-point in three months, meaning the 1,655 level in early October, the S&P 500 remained 55 points, or 3.4%, above its 200-day moving average. In short, the long-term trend never wavered and was never threatened during 2013.
How placid was the stock market year? The average daily rate of change in price on the S&P 500 for 2013, through 12/28/13, was a tame 0.55%. It is highly unusual for a strongly directional market to have such a low rate of daily change. For the market to advance 25% or more, as it has in 2013, you need lots of strong single-session moves higher, typically balanced by strong single-session reactive moves lower. For instance, when the market went down 38% in 2008, the daily rate of change was 1.74%; and when the market rebounded 24% in 2009, the daily rate of change was 1.24%. Even in 2011, when the S&P 500 ended the year within one index point of where it began, the daily rate of change was 1.04%. After averaging 1.22% for 2008-11, the daily rate of change has averaged 0.57% for 2012 and 2013. What happened? Basically, the bulls won. Because there have been few significant moves down in 2013, the market has not needed big single-session jumps to restore upward momentum. Instead, 2013 has been a year in which the market has ground quietly higher.
How broad was the stock market year? According to our sector tracker, every sector is up in 2013. Certain sectors (Consumer Discretionary, Healthcare, and Industrials) are the clear market leaders, with 30%-plus gains. Further, the interest-rate-sensitive sectors of Utilities and Telecom, along with Materials, are up "only" in high-single- to low-double-digits. But that said, the bulk of the market has participated in this rally. At no point in 2013 could investors point to a single-sector market or even a few-sector market. As of 12/28/13, a full 75% of stocks were trading above their 200-day moving average. That is a "Goldilocks" number, in that a reading in the 80%-90% range is consistent with an overbought market, whereas a percentage below 60% might signal a narrowing advance.
In short, 2013 has been solid, smooth, placid and broad…and mainly, it has been up.
The Stock Market in 2014
Given all that, what comes next for the stock market in 2014? Investors can (and should) look both to the technical perspective and the fundamental outlook.
From a technical perspective, the outlook is good. In the years since 1980 following 20%-plus gains in the stock market, the S&P 500 has appreciated by more than 20% a surprising nine times; and capital appreciation has averaged 13.1%. Only two of those years were negative; the S&P 500 declined 10% in 1981 and fell 7% in 1990. In both 1981 and 1990, the domestic economy was entering moderate recessionary periods. There is no sign of recession at present.
Fundamentally, we see a high likelihood of additional upward movement in interest rates. But rising rates do not necessarily doom the stock market, at least in the near term. We discussed this trend extensively in our June 2013 article, titled "When Yields Rise, Stocks Rise…For a While." Beginning back in the early 1950s, we examined every period in which the 10-year Treasury yield rose more than 20% over a six-month span.
What we discovered was that stocks, also measured on a six-month rate-of-change basis, tended to rise (often sharply) in these periods. We also looked at 12-month rate of change in bond yields and stocks. When bond yields rise more than 20% over 12 months, stocks perform less well. In periods in which rising yields coincide with rising inflation, such as in 1981, the 12-month rate of change in stocks quickly turns negative. But we also learned that in most periods, the decline in stocks occurred not amid rising yields. Instead, stock declines were more common when interest rates were falling. This occurred most often in periods of declining economic activity. Again, all signs point to accelerating rather than declining economic activity ahead.
While technical trends make for interesting color, our stock market forecast is based on fundamentals -- and the fundamentals look good. Argus Chief Market Strategist Peter Canelo points out that economic activity appears to be accelerating, based on GDP growth, employment gains, consumer-economy indicators (such as automotive, housing, and spending) and industrial-economy indicators (such as industrial activity, ISM and capacity utilization).
Economic expansion is vital to support earnings growth, which is vital to justify continued investment in the stock market. Thanks to ongoing profits growth and despite the multi-year rally, market valuations are not too dear. The S&P 500 trades at 15.1-times our 2014 EPS forecast, just above the five-year (2009-13) multiple of 14.5-times but below the historical forward multiple of 16.0-times. The multiple based on five-year "normalized" earnings is similarly below the historical average. Every bull market since World War II has ended with a period in which forward P/E multiples expand one or two points above the historical average.
The 2014 year will likely feature an unwinding of and perhaps the demise of QE. That will have unpredictable consequences on interest rates, the dollar and commodities. P/E multiples could contract if tapering fears cause interest rates to spike higher. P/E multiples could as easily expand if retail investor participation accelerates.
Our preliminary forecast for the S&P 500 for 2014 calls for high-single-digit to low-double-digit capital appreciation, with total return sweetened by the current 1.9% annual dividend yield. We caution that our forecast is a work in progress -- but we are bullish.
To put it in a nutshell, we like the market going into 2014 and we would be buyers.