The Times They Are A Changin'
Making year-end predictions is a losers' game. But change is the one constant of the stock market, and December is a convenient time to look at how the market's principal drivers could shift.
• Corporate earnings growth seems likely to accelerate in 2014, both for the capitalization-weighted S&P 500 Index and for the average U.S. company. Year-to-year growth in sales and per-share earnings for the median company in the broad S&P 1500 Index has picked up notably over the past year, and the U.S. economy seems on track for faster growth in 2014. Employment growth has jumped; home sales and construction are rising; and consumer confidence is rebounding. Also, the headwinds from Washington — including rising income taxes and partisan budget wrangling — are likely to abate. Overseas, leading indicators point to improved growth in Asia and a return to positive growth in Europe.
• Interest rates seem more likely to rise than fall in 2014, as the Federal Reserve has signaled it will cut back on its purchases of Treasury and mortgage bonds. But a reduction in Fed stimulus is widely expected, and bond yields have moved sideways over the past three months despite much-improved job growth. A move in 10-year Treasury bond yields above the September high near 3.0% would get Wall Street's attention, but stocks are cheap relative to bond yields based on price/earnings ratios. All else equal, it would take a move above 4.1% on the 10-year Treasury yield for stocks to look expensive versus 20-year norms based on this comparison.
• Inflation is widely expected to remain tame, with the Blue Chip Economic Indicators consensus projecting a 1.7% increase in the consumer price index for 2014. That is up from the 1.5% expected for full-year 2013. But the Fed's inflation target is 2.0%, and its preferred gauge of inflation has been rising more slowly than the consumer price index. A jump in inflation toward that target would be a big negative for stocks, since the Fed is unlikely to become more restrictive until the economy has sufficient momentum — unless inflation becomes a serious threat.
Inflation, one thing few on Wall Street are worried about, may be among the most important things to watch in 2014. We intend to keep a close eye on inflation reports and their impact on bond yields. We also intend to keep a close eye on the action of the Dow Industrials and Dow Transports, as the averages often signal a coming change in the investment climate. For now, with the Dow Theory in the bullish camp and quality stocks available at reasonable valuations, we are maintaining a nearly fully invested posture. Our buy lists have 95% to 99% in stocks. Top picks include the 2014 capital-gains favorites featured in Focus Favorites.