Barron's Cover

SATURDAY, DECEMBER 14, 2013

Bullish on 2014

By VITO J. RACANELLI

Wall Street strategists expect stocks to rise 10%, boosted by a stronger economy and fatter corporate profits. Bullish on tech, industrials.



Timeline: 2013 -- A Year to Remember


Following six years of manic performance, Wall Street's top strategists see a sense of normalcy returning to the financial markets next year. They expect the Federal Reserve to sharply reduce its $85 billion monthly bond-buying program, allowing interest rates to edge higher. And they see stocks rising about 10% on the basis of corporate fundamentals, instead of being whipsawed by every utterance from the Fed.

After a year in which the Dow has advanced 20% and the S&P 25%far more than almost anyone had predictedmore muted gains might seem boring. But boring could be just the ticket to inspire renewed confidence among investors in the markets and the financial system.

THE 10 STRATEGISTS Barron's consulted about the outlook for 2014 have year-end targets for the S&P of 1900 to 2100, well above Friday's close of 1775.32; their mean prediction is 1977. The bullish consensus might trouble contrarians, but Wall Street's pros see ample reason for optimism, given their expectations of a stronger economy and rising corporate profits.

In recent years, and especially in 2013, the market moved ahead because investors were willing to pay more for earnings. The Standard & Poor's 500 currently trades for almost 15 times analysts' next-12-month profit estimates, up from 13 times a year ago. Next year, however, the strategists expect earnings growth to do the heavy lifting, with S&P profits climbing 9%, compared with subpar gains of 5% in the past few years.

Specifically, the strategists eye S&P profits of $118, up from this year's estimated $108 to $109. Industry analysts typically have higher forecasts; their 2014 consensus is $122, according to Yardeni Research.

Profit growth will be driven mostly by a 2.7% increase in U.S. gross domestic product, which compares with this year's expected 1.7% gain. A more robust economy could encourage more capital spending and business investment, as well as more hiring, as corporate leaders see an uptick in customer demand.

Ironically, many market watchers believe that when the Fed tapers its bond-buying regimen, it will hasten an improvement in corporate confidence. For chief executives, such action, expected in the first quarter, would signal that the central bank sees a sustainable recovery, at last.

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Technology and industrial stocks could be the biggest beneficiaries of a better economy around the world, the Street's strategists say. Tech stocks, in particular, trade for relatively low price/earnings ratios, and many of the group's members have cash-rich balance sheets.

The strategists continue to recommend that investors steer clear of sectors such as consumer staples, consumer discretionary, utilities, and telecommunications. Staples stocks aren't as leveraged as other sectors to a reviving economy, and consumer-discretionary issues sport sky-high P/Es, relative to historic valuations. It wouldn't take much in the way of bad news to knock them down.

Utilities and telecom stocks have performed poorly this year, in part because, with their rich dividends, they act as bond proxies. They aren't expected to thrive in a rising-interest-rate environment. The consensus view is that yields on 10-year Treasury bonds will climb to 3.4% next year from a current 2.8%. The 10-year yielded as little as 1.75% a year ago.

OUR EXPERTS DON'T SEE everything coming up roses. In particular, they worry that the Fed could make missteps under its new boss, Janet Yellen, when it begins to remove stimulus from the markets next year. Yellen is scheduled to replace Chairman Ben Bernanke on Feb. 1, pending confirmation by Congress.

The Federal Reserve must get the timing of any move right, and also must make clear the distinction between tapering and an actual hike in its federal-funds-rate target, now a puny 0.25%. The Fed sets this benchmark rate, which banks charge one another on overnight loans. Our seers expect the central bank to hold the rate steady until sometime in 2015.

If the Fed doesn't communicate its intentions well, the tapering period could become a rocky one for the stock market. And if the tapering is followed by a sustained deceleration in economic growthwell, it's hard to imagine that stocks would remain aloft.

The strategists will be keeping an eye on Washington, too, in the event Congress can't reach an agreement in the spring on raising the federal debt ceiling. Last week's bipartisan budget deal offers some hope, at least, that politics won't derail the bull market. Likewise, stocks have held up despite wars and political crises in other parts of the world.

Here is a closer look at four key factors that will shape financial markets in 2014.

Corporate Earnings
The U.S. economy hasn't enjoyed much of a recovery since the financial crisis of 2007-08, notes David Kostin, U.S. equity strategist at Goldman Sachs. This could be the year: The firm expects GDP growth to rise to 3%, which could help spur earnings growth.

Employment data and figures from the Institute for Supply Management support hopes for a pickup, Kostin says. In November, the ISM manufacturing purchasing managers' index advanced for the sixth straight month, to 57.3 from 56.4. A reading above 50 signals economic expansion.



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Stephen Auth, Federated Investors' chief investment officer, is even more bullish. "We are entering Phase II of the bull—the return of an economics- and profit-growth-driven market," he declares.

Auth has been among the most consistently optimistic of the strategists we've consulted, and also on the mark. His year-end S&P target is the highest this year, as it was a year ago: 2100. Federated's forecast of 3.5% GDP growth in 2014 also tops the list.

"In the past five years, no one was making long-term investments," Auth says. As a result, corporations are sitting on $1 trillion of cash, and there is pent-up demand for investment around the world. Thomas Lee, the chief U.S. equity strategist at JPMorgan Chase, notes that U.S. gross fixed investment has fallen to 13% of GDP, on par with Greece and well below the 16% to 21% range that obtained from 1950 to 2007. Just getting back to the midpoint of that range would require additional spending of $600 billion, he observes.

VARIOUS ECONOMIC INDICATORS suggest that a recovery isn't limited to the U.S. The Organisation for Economic Cooperation and Development reported on Dec. 9 that composite leading indicators in most major countries, both developed and emerging, are showing signs of improvement.

Interviewed on their outlook for the fall ("Fall Forecast: Sunny," Sept. 2), many strategists said they expected signs of economic acceleration to be visible in the second half of the year. Indeed, that's been the case:

Investors applauded an upward revision in the third-quarter annualized GDP growth rate, to 3.6% from 2.8%, and a recent drop in unemployment, to 7% from 7.3%. But the bull is always hungry for more and better data.

Auth, of Federated, is looking for another leg up in the housing market, and in nonresidential construction. Gains in both would help to boost employment. Household balance sheets are in better shape, he notes, so consumer demand could remain steady.

The domestic boom in shale oil and gas is another boon to employment, and will lower energy costs for some industries, he adds.

The calendar, too, is a help. Addition will come from subtraction as the U.S. begins to lap some of the government's automatic spending cuts tied to the sequestration that began last spring, and the expiration of the Obama administration's 2% payroll-tax cut early this year. The government cost the economy perhaps 1.5 percentage points of GDP growth in 2013, but "government drag will be a lot less in 2014," predicts Auth.

Both people and companies will start to spend more in 2014, he adds.

To Taper—or Not?

That is the question—for the Fed, the economy, and Wall Street. Mere mention by the central bank of a desire to rein in its bond purchases sent jitters through the market this year. Stocks fell 6% last spring, after Bernanke, on May 22, broached the idea of stimulus removal.



When the tapering finally begins next year, the reaction might not be so negative, says Savita Subramanian, head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch. That's because a rotation out of rate-sensitive stocks, including utilities, telecoms, and real-estate investment trusts, already has begun. Moreover, "tapering in the context of an improving economy is something investors should be happy about," she says.

Adam Parker, head of U.S. equity strategy at Morgan Stanley, concurs: "Tapering won't be as negative as people think. The Fed will taper when the economic data has improved enough."

BAD NEWS WAS GOOD this year, as the market frequently wilted on strong economic numbers or other seemingly positive information that suggested the Fed's assist might be drawing to an end. Conversely, stocks often rose on weak economic numbers, which implied that the central bank would leave its zero-bound interest-rate policy in place. Lately, stocks have been rising on stronger economic results, another sign of creeping normalcy.


Our panel's predictions on year-end yields for the 10-year bond range widely, from 2.9% to 3.75%. (Bond prices move inversely to yields.)

Market Sectors
Jeffrey Knight, head of global asset allocation at Columbia Management, makes a strong case for industrial stocks, noting that "investors will increasingly gravitate to stocks correlated to the business cycle" as the economy picks up. Technology stocks, in particular, are leveraged to better economic growth.

While shares of the big hardware makers such as Microsoft (ticker: MSFT) and Cisco Systems (CSCO) are struggling, these stocks boast low valuations, and the companies have ample cash.

Russ Koesterich, global chief investment strategist at BlackRock, also is a fan of tech, noting the sector's impressive return on equity. Tech's ROE, based on trailing 12-month earnings, is 22%, significantly higher than the S&P's 15%. Also, technology outfits, which generally have little to no interest expense, won't be hurt by rising interest rates.

Despite its strengths, the tech sector doesn't trade at a premium to the market. The shares fetch 17 times trailing 12-month earnings, right in line with the S&P.

Koesterich also favors foreign stocks, which tend to be cheaper than U.S. issues. He recommends playing the global recovery in tech through exchange-traded funds, or ETFs, such as BlackRock iShares Global Tech (IXN). The table nearby highlights more stocks that our panelists believe will outperform the market in 2014.

Both industrials and techs offer international exposure, particularly to Europe and emerging markets, says Subramanian of BofA Merrill. European stocks have risen sharply, but U.S. stocks exposed to the Continent haven't seen comparable gains, she notes.

Cyclical stocks, which cross sector boundaries, are another favored group for 2014, given their economic sensitivity. According to JPMorgan's Lee, cyclicals, which include industrials, tech, materials, and consumer-discretionary shares, made the biggest contribution to year-over-year growth in third-quarter S&P 500 earnings. "That's a huge reversal from the first half of 2013," he says.

Yet cyclicals trade for 20 times trailing earnings, a big discount to many defensive issues.

Some market commentators have observed that profit margins are near all-time highs, suggesting limited room for expansion. But Tobias Levkovich, chief U.S. equity strategist at Citibank's Citi Research, calls that "malarkey." In eight of the 10 S&P sectors, margins on earnings before interest and taxes (Ebit) are lower than they were in 2007, which marked the previous high, he says.

Corporate America's bottom line has been helped by substantial declines in interest expenses and taxes. Although both are expected to rise next year, Levkovich still sees room for Ebit margins to widen as the recovery gathers steam.



CONSUMER-DISCRETIONARY SHARES have been big winners this year, but several strategists advise caution. "Discretionary has had a great run, and everyone loves and owns it," observes Subramanian.
Valuations are high, and she sees risks in multiple industries. Housing, she notes, has slowed a bit, and rising wages and costs related to health-care reform could hurt the retail and restaurant industries.

BlackRock's Koesterich agrees, noting that household income isn't rising rapidly, and that the labor market is growing more challenging for consumer-staples and discretionary stocks. "Many consumer stocks are priced for perfection," he says.



Investment Risks
The market made headway this year in part because investors' worst fears weren't realized. The U.S. didn't default on its debt; China didn't experience a hard economic landing, interest rates remained benign, and Europe's debt crisis abated. Yet, every sunny forecast is subject to clouds, and the outlook for 2014 is no different.

As noted, the timing and manner of the Fed's stimulus withdrawal could pose major problems for stocks. Yellen & Co. will have to walk a tightrope, curbing the central bank's bond-buying while ensuring that investors don't misinterpret the move as a prelude to an imminent rise in the fed-funds rate. The Fed's change in command also presents added risk. "The market was comfortable with Bernanke," says JPMorgan's Lee. Yellen has to establish credibility, and "the potential for error is there."

No matter how well executed, a change in Fed policy will bring new uncertainties to the stock market, notes Barry Knapp, U.S. equity strategist at Barclays Capital.

The market hasn't suffered a serious setback in nearly two years, and that is potentially problematic, too. "We've had a 40% rally in the past 18 months with no correction," says Goldman's Kostin. "It's hard to identify why, but an increased probability of a correction next year is worth emphasizing."

A bout of volatility around the start of tapering is a reasonable expectation, says Citi's Levkovich. Even if the tapering goes smoothly, the market will start to worry about a coming interest-rate hike. Columbia's Knight doesn't see a boost in the fed-funds rate in 2014, but anticipation of a policy change in 2015 could roil the waters next year.

THE CONSENSUS VIEW IS that economic growth will accelerate globally in 2014. If that prediction proves wrong, "there is much more downside risk than from tapering alone," Knapp says.

The strategist also is worried about the implementation of the Affordable Care Act, aka Obamacare, which got off to an inauspicious start this fall. Further problems could erode consumer confidence, he suggests.
Europe's economy looks to be on the mend, but the recovery could stall. "You could end up with a meaningful disappointment in Europe, relative to expectations," says Levkovich.

Given this year's unusual gains, some strategists have looked to the past for hints about future performance. But the history is mixed.

Federated's Auth, for example, studied the market's performance after two consecutive years of double-digit returns. In 50% of cases, stocks advanced the next year. He concludes that "two years of big rises is not a reason to be bullish."

THE CURRENT BULL MARKET began in March 2009, and the S&P 500 has rallied 162% since then. Typically, bull markets that last more than four years eventually are knocked off course because of a recession, says JPMorgan's Lee.

Our strategists don't see a recession in 2014, just as they don't see negative equity returns—or a third year of 20%-plus gains. Instead, they see an unremarkable 2014 unfolding. After the thrills and spills of the past five years, chances are investors wouldn't complain about that

Sector Snapshot
Only four sectors are beating the market this year, with consumer-discretionary in the lead. Bond-proxy sectors have been dragging.


Price Returns
S&P 500 Sector P/E* 2013** 2012 2011 2010
Consumer Disc 16.935.1%21.9%4.4%25.7%
Health Care 16.034.115.210.20.7
Industrials 15.730.312.5-2.923.9
Financials 12.928.226.3-18.410.8
Info Technology 13.420.313.11.39.1
Consumer Staples 16.620.37.510.510.7
Energy 12.617.42.32.817.9
Materials 15.315.812.2-11.619.9
Utilities 14.86.6-2.914.80.9
Telecom 14.03.612.50.812.3
S&P 500 14.5 24.5 13.4 0.0 12.8
*Based on 2014 analysts' earnings estimates. ** Through 12/12.
Source: Bloomberg


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