In a post last week, I explained why the interaction of two factors that defined the market last year - significant multiple expansion and higher interest rates - represents a headwind for stocks in 2014. While a stronger economy will help mitigate some of the pressure from higher rates and more lofty multiples, I still believe that stocks will have a harder go of it this year.
To be sure, as I write in my latest weekly commentary, the U.S. economy is showing definite signs of improvement, as evident in a recent pattern of strong data. Last week, the December reading of the ISM manufacturing survey, one of the more important statistics in my opinion, came in strong at 57, close to November's 2 ½ year high. Even better, the surge in new orders to the highest level since April of 2010 bodes well for first quarter growth, as new orders tend to lead economic activity.
However, while the economy's recent strength is good news for the economy and for those still looking for work, it's a two-edged sword for stocks. On the positive side, it should help boost corporate earnings in 2014.
But faster growth is also leading to higher interest rates, a risk for stocks as valuations are also higher. In 2013, U.S. equity market valuations rose by roughly 20%, the biggest increase since 1998. Historically, when both valuations and long-term rates have risen, market returns in the subsequent year have been more modest. In the 14 instances between 1954 and 2013 when multiples rose and the rate on the 10-year note rose, the average return on the S&P 500 in the following year was around 2% to 3%.
Does this mean that stocks are doomed to a year of near-zero returns? Not necessarily.
One factor that may mitigate the impact of higher rates and higher valuations is the fact that interest rates are rising from unusually low levels. At 3%, the yield on the 10-year Treasury is still well below the 20-year average of 4.5%. As such, stocks still look cheap relative to bonds and are still likely to advance in 2014. But given the headwind of higher rates and higher valuations, 2014 gains should be much more muted, slowing to a range of roughly mid to high single digits.
Given this, I continue to advocate that investors raise their exposure to international markets and cheaper parts of the U.S. market, such as large and mega cap stocks and the technology and energy sectors.