Stock Market Outlook 2014: Is The Rally Over?

Includes: SPY
by: Andrew Dickow

2013 has come to an end and what a year it was. With that said, what an unpredictable year 2014 is shaping up to be as well. Since the market bottom in the spring of 2009 the prevailing theme in the financial markets could be aptly described with the saying, "a rising tide lifts all boats." An improving and stable economy, combined with historically unprecedented and extremely favorable monetary policy, has pushed nearly every asset class up, and in some cases, to all-time highs.

2013 proved to be the first bump in the road for capital markets. Markets that would previously digest positive or negative news and still proceed higher and higher, as if all news was great news, finally saw some signs, although very minor, of weakness. 2013 represented a year in which the trend was broken. The 30-year trend of declining long-term interest rates reversed on talk of Fed tapering in the 3rd quarter. All interest rate sensitive asset classes immediately turned over and duration risk went from the back of investor's minds to the forefront. The graphic below depicts the divergence of interest rate sensitive asset classes and the impact developed country stock markets took once interest rates started to creep up.

Asset Class Index



U.S. Large Cap Stocks S&P 500



U.S. Small Cap Stocks Russell 2000



International Stocks MSCI EAFE Index



Emerging Market Stocks MSCI Emerging Market Index



High Yield Bonds Markit iBoxx USD Liquid HY Index



Investment Grade Bonds Barclays U.S. Aggregate Bond Index



Emerging Market Bonds JP Morgan EMBI Global Core Index



Commodities S&P GSCI-R Total Return Index



Gold London PM Fix



*March 1, 2009-December 31, 2012

At home, in the U.S.A., things could not be better for those who have invested in domestic stock markets since the end of the financial crisis. You basically could have thrown a dart at any U.S. stock and felt like an expert investor at any time over the last three years. The S&P 500 closed 2013 up 32.4%, and is up over 16.2% annually over the past 3 years and it shows no signs of slowing down. Where the market goes from here is less clear and there are many questions surrounding future returns. Is the market cheap or expensive? Is it in another bubble caused by loose monetary policy? Is it properly reflecting an improving economy? Are record profit margins going to stay at or near all time highs? The answer to these questions can be different depending on whom you ask and how you view the market. Investors who subscribe to valuing the market with the CAPE ratio (Cyclically Adjusted Price Earnings Ratio) would tell you the S&P 500 is dangerously overvalued, while someone using P/E ratios, using trailing twelve months or forward earnings, would tell you the market is fairly valued to slightly overpriced. Profit margins tend to be at the mean reverting, but the Fed plans on holding rates low for several more years. Who's to say they can't hold where they are during that period? Wall Street analysts are expecting the S&P 500 to be up about 6% in 2014, but rarely do forecasts prove accurate. Wall Street analysts expected a return of about 9% in 2013, so take their forecasts with a grain of salt. What this should tell you is to invest carefully. All too often, when you talk with individuals investing their own money, they are predominately investing on their own in stocks. This is a dangerous game to play, and while you may feel great at it now, in a market where investors could not miss, things can change quickly.

Fixed-income markets had a tough year, and the way investors look at them have changed drastically since the Fed's initial comments on tapering bond purchases. Interest rate risk has essentially been a theoretical risk investors knew they would deal with someday, but technically had not dealt with on a consistent basis since the late 1970s. Long-term treasury bonds, as measured by the Barclay's U.S. 20+ Year Treasury Bond Index, were down nearly 15% from May through July, one of the largest drawdowns in decades and much larger than any drawdown in supposedly much riskier equities. High Yield Corporates still had a positive year, essentially just earning their coupons, but their spread over Treasuries shrunk drastically. Investors now have to question how much more room they have to grow, beyond just clipping coupons. International and Emerging Market Bonds (both dollar and non-dollar denominated) took a beating from U.S. rates jumping, as most are priced (like all fixed-income instruments) on a spread over Treasuries. International bonds continue to earn the reputation for being incredibly volatile, but when you can only earn a 200 basis point spread over Treasuries in a risky domestic high yield bond, why would you not either buy the Treasury or go overseas for better yields with much better upside potential? When allocating to the fixed-income market, you should be very careful where you put your money and how it mixes with the risk profile of the rest of your portfolio.

There are a lot of questions about what 2014 and beyond may hold. The overall trend upwards may continue, but the hiccup in fixed-income in 2013 may be the first sign of the post crisis rally fading. In my opinion, mixed market performance across asset classes is a sign of a healthier market. That may seem like an odd comment from a market investor, after all, wouldn't it be nice if all investments were to go up forever? But single asset classes cannot and should not go up forever. All asset classes going up for long periods of time should not happen unless there are serious price distortions being created, which never ends very well. Just ask a homeowner who purchased a house late in the housing bubble, buying into the belief that housing prices would always go up. Investors should prepare for more volatility in all asset classes and prepare their investment portfolios' asset allocations carefully. With an uncertain trajectory for capital markets in 2014, intelligently diversifying your investment portfolios across multiple asset classes is the surest way to protect your capital. Historically it has proven to result in the best risk-adjusted returns. Since no investor knows what the future holds, a healthy mix of equities and fixed income of all regions combined with alternative asset classes tailored for your personal risk tolerance is where you should be investing your capital.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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