2014 Stock Market Outlook: More Gains

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By Anne Kates Smith

So the phenomenal rally raises the question: Where is the market getting its strength? And more important, can this aging bull continue to run? Our answer: Don't give up on the bull yet -- it may be younger than it looks. "We don't see a bear market coming," says Henry Smith, chief investment officer of Haverford Trust. "We believe that March 2009 represented a generational low, and that this is the middle of a sustained bull market."

Another year of gains will be supported by stronger economic and corporate underpinnings, and, just as important, improving sentiment among investors. By most measures, stocks are fairly priced, if not bargains. Given expected earnings growth of nearly 10 percent in 2014, we think stock prices could rise that much and perhaps more if investors again prove themselves willing to pay more for each dollar of corporate profits, ratcheting up the market's price-earnings ratio. A reasonable range to expect would be 8 percent to 12 percent returns, including dividends. An 8 percent price gain would put the S&P 500 (^GPSC) in the vicinity of 1,944, translating into roughly 17,300 on the Dow Jones industrial average (^DJI); a 10 percent gain would put the S&P 500 at 1,980, the Dow a bit over 17,600. With dividends, the S&P's returns could reach 12 percent.

Despite the wounds inflicted by squabbling lawmakers in Washington, the U.S. economy will continue to improve in 2014, with gross domestic product growing 2.6 percent, up from our estimate of 1.5 percent in 2013. For the first time since the Great Recession, consumers will see wages grow faster than inflation, with personal income rising at least 3.5 percent and inflation about 2 percent. %VIRTUAL-article-sponsoredlinks%Companies will continue to add to payrolls, with the unemployment rate fluctuating between 6.9 percent and 7.2 percent as more people decide to resume searching for work. To keep the economic wheels greased, the Fed will likely keep short-term interest rates near zero until 2015, but longer-term rates will rise as investors begin to anticipate an acceleration of economic growth. Look for the benchmark ten-year Treasury bond to end 2014 with a yield of 3.3 percent, up from 2.8 percent today.

Housing is a pocket of economic strength, with new-home sales expected to jump 16 percent. Outside the U.S., exports could rise by 4 percent as Europe's economy convalesces and China's slowdown levels out. Economists at IHS Global Insight expect global economic growth of 3.3 percent in 2014, up from an expected 2.4 percent in 2013. Among the challenges in the U.S. will be the fiscal uncertainty that bleeds into early 2014 as Congress wrangles with the level of government spending and with raising the debt ceiling (also known as giving Uncle Sam the wherewithal to pay his IOUs).

But the Federal Reserve holds the real wild card. Most Fed watchers expect the central bank to begin cutting back its massive, $85-billion-per-month bond-buying program in the first quarter. Last summer, the market swooned at mere rumors that the Fed was set to taper its stimulus. Dan Morris, global investment strategist for TIAA-CREF, notes that from the time the Fed's two previous "quantitative easing" programs ended (in March 2010 and June 2011) until the next easing program was hinted at, the S&P 500 fell 9 percent and 12 percent, respectively.

At taper time, "the markets will take fright, yields will go up, there'll be volatility," Morris says. "You could see a 10 percent correction, but people need to ride through it."

The Upside of Fed Tightening

That's because tapering won't commence until the economy is robust enough to withstand it. Recall the surprise when the Fed confounded market expectations by not tapering last September. The implication, says BMO Capital Markets strategist Brian Belski, is that tapering won't begin until "there is incontrovertible evidence that the economy has reached escape velocity." And you can expect much the same Fed policy to continue when Janet Yellen moves from board member to chairman early in 2014.

When it comes to corporate earnings, investors should focus less on absolute growth rates and more on the nature of the profits. After strong gains at the start of a recovery, it's not unusual for earnings growth rates to flatten out. But a profit peak is still years away, says Christopher Hyzy, chief investment officer of U.S. Trust.

Conspicuously missing from the profit picture in recent years has been a convincing pickup in revenues; instead, companies have engineered big chunks of profit gains through relentless cost-cutting. That could change in 2014 as consumer and business demand for goods and services finally picks up, and sales become a greater factor in driving profits. The period "is likely to be characterized as the dawn of a new business cycle," Hyzy says.

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2014 Stock Market Outlook: More Gains

Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for two thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don't start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That's unfortunate, and there's no way to fix it retroactively. It's a good reminder of how important it is to teach young people to start saving as soon as possible.

Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That's really all there is to it.

The dividend yield we know: It's currently 2%. A reasonable guess of future earnings growth is 5% a year. What about the change in earnings multiples? That's totally unknowable.

Earnings multiples reflect people's feelings about the future. And there's just no way to know what people are going to think about the future in the future. How could you?

If someone said, "I think most people will be in a 10% better mood in the year 2023," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012. That's great! And they didn't need to know a thing about portfolio management, technical analysis, or suffer through a single segment of "The Lighting Round."

Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96% total return -- still short of an index fund.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it's not like golf: The spectators have a pretty good chance of humbling the pros.

Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time -- every single time -- there's even a hint of volatility, the same cry is heard from the investing public: "What is going on?!"

Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.

Since 1900 the S&P 500 (^GSPC) has returned about 6% per year, but the average difference between any year's highest close and lowest close is 23%. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.

Someone once asked J.P. Morgan what the market will do. "It will fluctuate," he allegedly said. Truer words have never been spoken.

The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he'll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.

"Everything else is cream cheese."
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