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Equity markets were the obvious winner in 2013; almost all sectors experienced double digit gains with Industrials, Healthcare, Technology, and Social Media taking the charge. Many catalysts are responsible for excessive growth and the future of US equity markets has never been more uncertain. Most analysts have valid reasons for why they think markets will be up or down in 2014, but one thing they all agree on is that the 30% gains achieved in 2013 will not be as easily reached in the upcoming years.

Obviously, US equity markets benefited from the Fed increasing the money supply by buying US Treasuries known as Quantitative Easing (QE). Before November 2008, the Fed had about $700-$800 billion of Treasury Bonds on its balance sheet, and it currently has over $4 trillion! This influx of free cash flow kept interest rates low, reduced the value of the US dollar, and increased borrowing; a recipe for increased foreign investment, increased exports, expansion and of course a killer year for equity markets. QE has been debated for the past five years as to whether or not the Fed should be pumping money in at the rate it did but who's to say what the unintended consequence of not doing QE would be? Check out the graph below for a different perspective:

(click to enlarge)

This graph shows the Central Banks' balance sheet as a percent of GDP. It is obvious that the Fed has done a lot of spending but look at it in comparison to ECB and BOJ.

The Japanese Yen is expensive and Japan has had over two decades of deflation affecting its economy. By increasing the money supply, the BOJ is reversing the effect of deflation and reducing the value of the Yen. Japan is planning to increase its balance sheet to 120% of GDP! This is way more than the Fed pumped into the US and will have an exaggerated effect on Japanese markets and will provide for some interesting investing opportunities.

Remember how quick US equity markets grew with the help of the Fed? Well consider what's going to happen to the Japanese equity markets in the next 1-5 years. Japanese markets will be seeing year over year returns of 60, 90, even over 100% making the 2013 US 30% gains look like peanuts. However, if the Yen is decreasing in value rapidly, the translation expense back to USD could be significant. This logic provides a few great opportunities for 2014 and beyond:

1) Invest in Japanese ETFs such as DXJ or EWJ.

2) Borrow in Japanese yen, and invest in US money markets. You will pay off the borrowed JPY with less USD because the JPY will have declined.

3) Use futures to lock in gains on the Yen (JPY/USD).

For example, if you were to borrow $1M in JPY (102.17JPY) today for 5 years at a fixed annual rate of 3%, you will owe approximately 114.99JPY on February 2019 which is $1.13 if the USD/JPY remains constant. However, if the value of the Yen decreases by say 25% in that time (conservative figure considering how much BOJ is increasing the money supply), 114.99JPY will cost you $900,405. Without even investing the original 102.17JPY in US markets, you net about $100K (11%) by just having the borrowed funds sit in cash for 5 years. Imagine the gains you could make with the borrowed funds growing in US markets.

There are also some great opportunities in US markets for 2014. Equity markets are well ahead of the underlying economies which ultimately support sustainable growth. 2013 was the year of momentum. Valuations on individual stocks are higher than ever which seems nostalgic to the housing markets five to six years ago and technology bubble eight years before that. Now I am not saying there is a bubble in the midst but 2013 could be the beginning of one.

If momentum keeps valuations high without actual growth and support for the valuations, the coming years could be rough for some industries. Most notably, technology and social media have huge valuations compared to industry future PE standards. Individual stocks like LinkedIn (LNKD), Yelp (YELP), Groupon (GRPN), Tesla (TSLA), Facebook (FB) and others are at risk, especially if we only see modest growth in other markets.

At the same time, as the US and other world economies catch up to the equities markets, some industries will be coming along for the ride. Real estate saw very modest growth in 2013 compared to US equities and as such it could be set up for outperforming growth in 2014. Investing in real estate ETFs would be a relatively low risk opportunity for large gains this year. Consumer staples, Energy and Financials are also set up for an outperform. Rising interest rates could prove a slow start to these industries, but as more investors move into cash, using 2013 gains, we may see tremendous growth. History shows that after bull years in the market, these industries take off in the years that follow. Home improvement and design stores as well as construction companies are another industry that will take off with real estate.

Overall, 2014 will not be 2013. It will take more strategy, patience and perseverance to make the same gains this year. 2014 and even 2015 will be time the market consolidates and the economy catches up to the value the equity markets put on the individual companies. As mentioned, there are opportunities for sectors that did not share in the same type of gains as the overall market and those industries could outperform this year. Look to see major consolidation in overvalued individual companies relative to their industry and market in general. If momentum prevails and we see underlying financials move farther and farther away from valuations, the next bubble could be a reality.

My idea of an ideal portfolio for 2014 is to use 60% borrowed JPY to invest in money markets to make gains for the decline of the JPY. Invest some of the borrowed yen in US equity markets. I will hold technology to ride momentum but not for fundamentals. Consumer staples, energy, and real estate will be my focus in the next few years. I will take advantage of the relatively low mortgage rates to invest in real estate projects as well as individual companies that benefit from a strong real estate growth such as home improvement or construction companies. One company set up for a good move is TEX.

Source: The Right Investments For 2014