In a post last week, I explained why the interaction of two
factors that defined the market last year -
significant multiple expansion and higher interest rates
- represents a headwind for stocks in 2014. While a stronger
economy will help mitigate some of the pressure from higher rates
and more lofty
, I still believe that stocks will have a harder go of it this
To be sure, as I write in
my latest weekly commentary
, the U.S. economy is showing definite signs of improvement, as
evident in a recent pattern of strong data. Last week,
the December reading of the ISM manufacturing
, one of
more important statistics in my opinion
, came in strong at 57, close to November's 2 ½ year high. Even
the surge in new orders
to the highest level since April of 2010 bodes well for first
quarter growth, as new orders tend to lead economic activity.
However, while the economy's recent strength is good news for
the economy and for those still looking for work, it's a
two-edged sword for stocks. On the positive side, it should help
boost corporate earnings in 2014.
But faster growth is also leading to higher interest rates, a
risk for stocks as valuations are also higher. In 2013, U.S.
equity market valuations rose by roughly 20%, the biggest
increase since 1998. Historically, when both valuations and
long-term rates have risen, market returns in the subsequent year
have been more modest. In the 14 instances between 1954 and 2013
when multiples rose and the rate on the 10-year note rose, the
average return on the S&P 500 in the following year was
around 2% to 3%.
Does this mean that stocks are doomed to a year of near-zero
returns? Not necessarily.
One factor that may mitigate the impact of higher rates and
higher valuations is the fact that interest rates are rising from
unusually low levels. At 3%, the yield on the 10-year Treasury is
still well below the 20-year average of 4.5%. As such,
stocks still look cheap relative to bonds and are
still likely to advance in 2014
. But given the headwind of higher rates and higher valuations,
2014 gains should be much more muted, slowing to a range of
roughly mid to high single digits.
Given this, I continue to advocate that investors
raise their exposure to international markets
cheaper parts of the U.S. market
, such as
large and mega cap stocks and the technology and
Russ Koesterich, CFA, is the Chief Investment Strategist
for BlackRock and iShares Chief Global Investment Strategist.
He is a regular contributor to
and you can find more of his posts
Sources: BlackRock research, Bloomberg
International investments may involve risk of capital loss
from unfavorable fluctuation in currency values, from
differences in generally accepted accounting principles or from
economic or political instability in other nations.
Narrowly focused investments may exhibit higher