The Times They Are A Changin'

12/16/2013


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.

Conclusion

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.


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