Outlook 2014.

January 13, 2014

2013 underscored an enduring idea that investors best not forget: politics be damned, the stock market is a universe unto itself.

Washington D.C. resembled a WWE main event. Complete with superstars, divas, pile drivers and head butts. The Middle East succumbed to another self-induced conflagration. The Far East dealt with fallout - both political and nuclear. And Russia prepared for the Olympics while essentially reestablishing itself as a dictatorship.

Throughout, investors, as well as many investment advisors, continued to suffer from the cognitive dissonance wrought by the 2008 credit crisis.

Most believe that the economy has stabilized. Is slowly strengthening. Yet, many remain woefully underweighted to stocks. Even as bonds declined against a backdrop of rising interest rates.

The lingering dissonance is understandable given the issues confronted these last two years. U.S. debt downgrades. Fiscal cliffs. Sequesters. Government shutdowns. Dodd-Frank. The threat of rising interest rates. China's anticipated implosion. Europe's debt crisis. Fukushima. Potential U.S. debt defaults. The Arab Spring. North Korea. Iran. Egypt. Syria.

Little wonder investors have been as anxious as a lightning-strike survivor in a thunderstorm. While a decade of fear and greed positioned markets for the best of all scenarios, investors obsessed over the next financial apocalypse.

Still, stocks continued higher.

All Quiet on the Western Front?

Aside from the continuing ObamaCare saga, this year sets up for relative tranquility. That is, as much tranquility as one can enjoy in a society driven by a myriad of 24/7 cable and network news organizations striving to uncover the next ad-selling catastrophe.

Sure, we have the midterm elections. But markets won't sweat that. And after last year's Greek tragicomedy, D.C. is weary of raising the electorate's ire.

Moreover, the current environment appears relatively serene. Tapering is baked in. Bond yields are unlikely to surge in the short-to-intermediate term. GDP and earnings guidance have been raised. We've seen more recent political cooperation than we have the last half decade. The American industrial renaissances continues to build momentum. Central banks remain accommodative. U.S. energy independence appears increasingly likely.

In lieu of everything, investor's remain schizophrenic.

Goldman Sachs' Abby Joseph Cohen and Legg Mason's Bill Miller, both of whom were remarkably prescient in their 2013 forecasts, agree that equities could climb another 20 percent this year. Further, the market's relentless rise seems to have tamed all but a few perma-bears. Contrarily, many investors, both retail and institutional, continue to hold large cash positions.

So, what can investors expect from 2014?

Economically Speaking

Tapering signifies that the U.S. economy is normalizing. And while 2014 growth will be mediocre, it should continue to improve.

2013 GDP growth was 1.9 percent. The forecasts for 2014 range between 2 and 2.8 percent. Most economists agree that there is little-to-no chance for a near-term recession.

Of course, most dismal scientists missed the mark entirely in 2008. But, they have data on their side.

Unemployment is picking up. Purchasing manager's indexes have improved. As has industrial production. Inflation remains stable. And interest rates should remain near zero into 2015. If D.C. can serve as less of an economic drag, GDP growth could approach 3 percent. That's below the typical levels at this stage in the business cycle, but could be a technical and psychological boon for stocks.

Welcome Back, Volatility

After five years of market gains, not to mention last year's volatility vacuum, we do not expect the ride to remain smooth. Markets have not only climbed the proverbial wall of worry. They've scaled the cliffs of fear. With investors making decisions amidst a constant expectation of a correction that never arrived.

Investing involves regular, if inconsistent, mean reversion. So, expect volatility to reappear in 2014.

The culprits?

Perhaps Europe hiccups. Perhaps the Fed decides to raise interest rates sooner than expected. Or the Middle East implodes into a conflagration of sectarian violence. Causing energy prices to spike. Or, some unforeseen natural or geopolitical fault line shifts, bringing panic and turmoil.

In 2013, the U.S. government threatened default. The government shut down. Yet, markets yawned. Today, as investors grow increasingly comfortable, expect a curve ball to disrupt the placidity.

Oscar Wilde quipped, "To expect the unexpected shows a thoroughly modern intellect."

So we will. Because when we least expect it, something will shake investors from their complacency. Some drama that surprises everyone. Causing volatility to jump like cats on a hot tin roof.

Stocks: The Trend is Your Friend

The S&P 500 ended the year up 29.60 percent. A gift from the market gods. Yet, stocks enter 2014 overbought. A correction is long overdue. And this week's Investor's Intelligence survey hit a bullish extreme that usually portends a market top. The probability of a 10 percent correction to wring out the excess increases weekly.

Still, 2013 demonstrated that such overbought conditions can be greeted with moderate pullbacks and consolidations. Yet, considering the ferocity of last year's move, as well as the dearth of downside, we would not be surprised by a more pronounced drop.

By its nature, the stock market doesn't care about absolutes. Good or bad. The market is a pricing mechanism. It concerns itself with whether things are becoming better or worse. We believe that things continue to improve. Accordingly, we believe that the trend remains upward. Though this year's market will likely involve more peaks and valleys than did 2013.

Why the cautious optimism? Too many forces pushing equities higher. They include:

-Money flows from bonds into stocks for the first time since 2007.

-Equities are more expensive than a year ago, but remain more attractive than bonds and cash.

-If the S&P 500 remains at its current multiple (17x), it stands to reason that the market can rise significantly so long as 2014 earnings estimates are near their targets. With mean earnings projections at $117.20, a multiple of 17x would see the S&P rise to roughly 1,992. That's a 10-percent gain.

Click here for a look at some year-end targets for the S&P 500.

Investors beware, however. As this stage in the business cycle typically sees uncertainty decline and confidence on the rise. This results in less risk aversion, as investors move from cash and bonds into equities. Eventually, that excessive optimism leads to a meaningful decline. March? April? Nobody knows. But it's out there.

Fixed Income's Rocky Road

Aside from the certainty of uncertainty, the idea of which we can most be sure is continuing volatility in fixed income markets. As rising interest rates approach, the multi-decade bond bull will turn bearish.

We don't worry about a cataclysmic rise in rates, as some are predicting. It is the unintended consequences that wake us from our nightly slumber.

What will be the psychological impact of rising bond rates on those institutional trading firms, hedge or sovereign wealth funds, as rates rise? Which of these institutions has made large, leveraged interest rate bets via the massive derivatives markets? What happens as these unwind?

Warren Buffett called derivatives "financial weapons of mass destruction." And so it is not the seen, but the unseen, that worries us.

Yet, fixed income is not the mine field everyone has made it out to be. With inflation low and rates likely to rise, non-government taxable bonds, high yield bonds and, possibly, municipals provide opportunities. TIPS and long-dated Treasuries, however, should be avoided.

House of Cards

As markets healed these last five years, and the 13-year consolidation period the S&P 500 began in 2000 ended with new all-time highs, we often found the biggest impediment to progress were those in our nation's capital. Crisis after crisis. In perpetuity.

Yet, even with November's mid-term election, this could be the year that politics gets out of the way.

Nobody in Congress wants to antagonize the middle class heading into the midterms. And D.C.'s denizens recognize, based on their dreary poll numbers, that voters are exhausted by the constant turmoil.

Better yet, the smell of compromise is in the air.

The fragile budget deal remains intact. It may remove the threat of yet another debt ceiling debacle and the annual government shutdown. True, partisan warfare over government spending may arise. But, the recent agreement ends a three-year budget fight and establishes Federal spending through 2015.

As the 2011 debt ceiling battle catalyzed the last real correction, we can at least remove that obstacle.

Finally, there may be talk of new taxes on the wealthy, but there's not likely to be much movement. Especially given that the wealthy were stuck like pigs on January 1.

ObamaCare will receive its daily headlines. But, even that boiling rabbit is likely to improve.

So, even with November's election, perhaps this year will be less political. Knock on wood, my friends. One can hope.

Foreign Affairs

Overseas? A mixed bag.

Many emerging economies, especially those in the Middle East, are dealing with massive unrest. Syria, Iraq, Iran, Egypt, Turkey, Lebanon, and multiple African nations -- Shiite versus Sunni violence appears ready to drag the entire region back into the stone ages.

The unintended consequences relating to energy prices and geopolitics are disconcerting. Remember, WWI began with the assassination of an archduke on a shopping trip. And with a strengthening dollar threatening to further weaken emerging economies, that could destabilize these fragile situations.

That said, China appears to be emerging from its economic slump. Its reemergence would be a tonic for many of the natural-resource based emerging markets economies.

In Europe, the economic recovery there has not been fully appreciated. It was just last year that many thought the eurozone was on the verge of collapse. While fear and uncertainty still permeate the landscape, the economic trends in last year's problem nations are improving. As are the opportunities.

Spain, Italy, Portugal and Ireland have made quantum leaps. England ended its recession. And Germany continues to lead the way. GDP is growing throughout much of the Eurozone, having already surpassed expectations.

Greece reeks of instability. But, even the Greeks have begun to right their once sinking ship. And with European equities having been beaten so far down, we believe the opportunity for continued outperformance exists for risk-attuned investors.

Conclusions and Action Steps

2013 was a great year for stocks. Still, many investors failed to participate due to lingering fears from 2008.  While stocks will continue to climb the wall of worry, we believe that opportunities remain. But, they will come at a price.

A reversion to more typical market volatility will serve to dampen investor enthusiasm, just as buyers begin to return. Still, these bouts of volatility will provide buying opportunities for those willing to put capital to work as others flee.

The typical precursors to large market corrections, those being spikes in inflation and energy prices, are not evident. Geopolitics could serve as a correction catalyst, yet the market has proven its ability to acclimate quickly to such events.

Understanding the above, we believe the following will represent areas of opportunity and misfortune in this year's marketplace:

We are bullish on:

Domestic equities...

-Dividend-oriented large caps will provide income to buffer the peaks and valleys.

-Small caps appear to be benefiting by the current rotation and will provide opportunities for outperformance.

-We believe growth stocks will outperform value, as they typically do at this stage in the cycle.

Developed foreign equities...

-After having been thoroughly decimated, European equities offer yield, continuing value and upside, especially as Europe continues to stabilize.

U.S. corporate spin-offs...

-These newly issued shares will continue to offer excellent risk-to-reward opportunities as the marketplace, both consumer and investment, acclimate to their arrival.

Non-Government fixed income...

-Investors should focus on corporate and high yield bonds, which typically fare better in rising rate environments.

-Municipal and floating rate bonds may also provide opportunities.

Secular trends...

-As we've often discussed, we see value in a variety of positions related to the U.S. natural gas revolution, data storage and computing technologies, healthcare and biotech, as well as discretionary companies tied to the housing recovery.


-Selling covered-calls and naked puts will proffer income enhancement opportunities to buoy astute investors when markets trend sideways.

We are bearish on:

Commodities and commodities stocks...

-Until China recovers, and China's emerging market clients find their footing, these natural resources and related stocks should be avoided.

Treasury Inflation Protected Securities (TIPS)...

-Down roughly eight percent last year, even the allusion of rising rates will continue to roil these positions.

Long-Dated Treasuries and Government Bonds...

-Short of some geopolitically inspired flight to safety, government bonds will be volatile without corresponding upside opportunities.

Emerging Market Stocks...

-While there is potential for risk-attuned investors, we believe that EM stocks will not offer enough reward to justify the risks, especially through the first half of the year.

Hedge Funds...

-Having underperformed for five straight years, and sensing that the client exodus may continue, the additional pressure on HF managers to justify their outsized fees will not assist their cause.

Bottom Line?

Increased volatility. Upside opportunity. Geopolitical turmoil. That's the environment in which today's investors operate. Have a plan. Execute it efficiently. Don't let headlines and volatility shake you from your convictions.

And have your downside protection parameters in place. Because in this uncertain world, we are certain that 2014 will be ripe with excitement.

Happy New Years to you and yours.

Securities offered through Dempsey Lord Smith LLC – Dempsey Lord Smith LLC, Rome, GA Member FINRA / SIPC / MSRB.

Advisory Services offered through Dempsey Lord Smith, LLC, an SEC Registered Investment Advisor. Clearing through and accounts held at Charles Schwab & Co., Inc.

Dempsey Lord Smith, LLC nor Hyde Park Wealth Advisors LLC provides tax or legal advice and you should consult your accountant and/or attorney if considering an investment of this type. Hyde Park Wealth Advisors LLC is not controlled by or a subsidiary of Dempsey Lord Smith LLC. Investing in Alternative Investments come with a variety of risks that could result in a complete loss of principal investment.

Alternative Investments offered as private placement securities are offered only to qualified accredited investors via confidential private placement memorandum. Income and returns are not guaranteed and there are no assurances investments will meet their stated objectives.

© 2024 Hyde Park Wealth Advisors. All Rights Reserved