Remember when you were younger, full of exuberance and able to
jump higher and run faster? Was it only last year that a charging
bull delivered a 32% return to investors in the U.S. stock market?
The bull has matured and is now facing some of the setbacks of
middle age. So far this year, Standard & Poor's 500-stock index
has returned just 3%. Still, we're convinced that the bull market
has got plenty of life left, so don't give up on it yet.
In our January issue, we predicted that the S&P 500 would
finish the year in the vicinity of 1900, and the Dow Jones
industrial average would close above 17,000. At midyear, we still
think that's a good, conservative bet, although it's possible that
stocks could tack on a little more--with the S&P closing
between 1950 and 2000. That would produce gains of 6% for the year
and would translate to roughly 17,500 for the Dow. Stock returns
will mirror growth in corporate earnings, which analysts estimate
at 6% to 7% this year. Dividends will add another two percentage
points to the market's return.
But the market has grown more complicated, with a lot going on
beneath the surface. The tide is no longer lifting all boats--in
order to prosper, you'll have to be choosier about where you
invest. Many of yesterday's market leaders are becoming today's
laggards, making for choppier waters overall. In general, we think
the rest of the year will favor larger companies over smaller ones;
companies that sell at reasonable values over high-growth,
high-priced stocks; and companies that are more sensitive to
improvement in the economy than those considered more defensive. (
All prices and returns are as of April 30.)
Five-plus years into the bull market, "2014 will be a big test,"
says Matthew Berler, co-manager of the Osterweis Fund. Investors
will grade the bull on how well it manages some midlife crises--or,
if not crises, at least challenges.
Readying for higher rates
The bull's first challenge will be making the transition from a
market driven by super-easy monetary policies and little
competition from fixed-income investments to one more focused on
corporate profits. The Federal Reserve is unwinding its bond-buying
program aimed at keeping long-term rates low and will eventually
look toward raising short-term rates, most likely next year. As
investors begin to anticipate that tightening, the market could
suffer a 5% to 10% pullback, perhaps in the fourth quarter, says
David Joy, chief market strategist at Ameriprise Financial . But if
raising interest rates to a more normal level is seen as a vote of
confidence in the economy, as he suspects will be the case, then it
won't be the end of the bull market.
As for earnings growth, companies must become less dependent on
the plump profit margins engineered by cost-cutting and other
maneuvers and more reliant on revenue growth. "I'm cautious," says
John Toohey, who directs stock investments for USAA. "And my
caution revolves around one theme: We need to see more revenue
growth." Since the financial crisis, per-share earnings growth has
been strong as companies have cut costs, refinanced high-cost debt,
lowered tax bills and bought back shares. A recent spike in mergers
and buyouts is aimed at buying revenue growth, Toohey adds. But he
and others would prefer to see more growth coming from actually
selling more goods and services. "We're a little surprised we
haven't seen it yet," says Toohey.
Such growth will hinge on whether the economy can finally
expects gross domestic product to expand by 2.4% this year, up from
1.9% growth in 2013, with the growth rate picking up to 3% or
better in the second half
. Many of those who are optimistic about the economy and the stock
market are pinning their hopes on another crucial transition--the
one in which companies segue from stockpiling cash to spending it.
"We're five years out from the Great Recession," says Joseph
Quinlan, chief market strategist at U.S. Trust, Bank of America
Private Wealth Management. "Companies have been hoarding cash. The
next five years will be about deploying it."
In recent years, companies have spent generously on dividends
and share buybacks. But a resurgence in corporate spending on
physical assets, such as factories, equipment and office space, has
been the missing link to more robust economic growth. Such capital
expenditures are part of a virtuous cycle as increasing production
necessitates spending, in turn creating jobs and income growth,
which then increases consumer demand, boosting corporate revenues
The time is ripe for a capital-spending recovery. With some $1.6
trillion on the books of S&P 500 firms as of year-end, cash
stockpiles are enormous. Commercial and industrial lending is also
picking up. And companies are nearing the point at which they
can't squeeze any more production out of existing plants and
equipment. The average U.S. structure, be it a power plant,
hospital or restaurant, is 22 years old. That's close to a 50-year
high, reports Bank of America Merrill Lynch. The average age of
business equipment, including computers and machinery, is more than
seven years old, the highest since 1995.
Buybacks lose favor
Meanwhile, spending on share buybacks, a winning strategy until
recently, is now penalizing companies and investors as rising stock
prices make such programs expensive. The 20% of companies with the
largest number of share buybacks in relation to their respective
market values outpaced the S&P by nearly nine percentage points
in 2013 but lagged the index slightly in the first quarter of 2014,
says BMO Capital Markets. Shareholders are voicing their preference
for spending on capital equipment over buybacks, dividends and
Bank of America Merrill Lynch sees capital spending growing at a
rate of 4.7% this year and 5.7% next year, more than double the
2.6% growth rate in 2013. Beneficiaries of a spending boom would
include tech, industrial and energy companies, as well as companies
that discover and process raw materials. These economy-sensitive
sectors together account for more than 40% of revenues generated by
S&P 500 companies.
Tilting your portfolio toward economy-sensitive stocks in
general is in order as economic growth picks up, and a number of
money managers favor these so-called cyclical stocks. USAA's Toohey
recommends Eaton Corp. (symbol
), a maker of industrial equipment. The 2012 acquisition of Cooper
Industries is boosting revenues at the company's electrical
products and services unit, its biggest division. Jim Stack, of
InvesTech Research, is a fan of software giant Oracle Corp. (
), which has attractive growth opportunities in cloud computing and
is trading at just 13 times estimated year-ahead earnings.
Osterweis manager Berler likes Occidental Petroleum (
), a resource-rich energy company that has decades' worth of
drilling opportunities with its existing assets, as well as one of
the strongest balance sheets in the industry. Investors interested
in owning a broad array of industrial concerns can explore iShares
U.S. Industrials (
), an exchange-traded fund.
Even if all goes according to the bullish scenario, however,
investors will soon realize that investing in a bull market
approaching senior-citizen status is different than what they've
grown used to. Until recently, for instance, a winning strategy for
investors was simply to buy and stick with winning stocks. But a
momentum-based approach is no longer working. For evidence, look no
further than the recent fall of high-flying biotech and social
media issues. The Nasdaq Biotechnology index has fallen 16% from
its February 25 peak, and shares of social media standouts Twitter
) and LinkedIn (
) have plunged 48% and 40%, respectively, from their recent
The good news is that the market's most overpriced sectors are
retreating without bringing the broader market down with them.
"Bubble talk was applied broadly to the market, but really applied
to only those high-flying areas," says Liz Ann Sonders, chief
investment strategist at
& Co. Stocks overall are still fairly valued, if no longer
cheap. Based on estimated year-ahead profits, the S&P 500's
price-earnings ratio is 15--a tad below the long-term average and
well below the levels of past market peaks. If the market's hot
spots can cool down on their own, "it's possible we can wring out
the excesses without a major calamity," says Sonders.
The perils of politics
That's unless Washington roils the markets again. Midterm
election years bring political uncertainty and stock market
volatility. In every midterm election year since 1962, says
Sonders, the market has corrected, sometimes viciously, with
average declines of 19%. But patient investors are rewarded,
because 100% of the time, the market has rallied--and
significantly, with average gains of 32% for the 12 months
following the correction. Geopolitical upsets--especially in
reaction to Russia's activity in Ukraine--are another worry. "There
may not be a fighting war, but an economic war could have an effect
on the global economy," says David Kelly, of J.P. Morgan Funds
Whether or not a major pullback occurs, investors should expect
continued shifts in winning styles and sectors. For example, the
long winning streak of small-company stocks is likely coming to an
end. From the market bottom in March 2009 until March 4 of this
year, cumulative price gains for the small fry far outpaced their
blue-chip brethren: 228% for the Russell 2000, a small-company
index, compared with 178% for the S&P 500, more of a
large-company barometer. But since its recent peak, the Russell
2000 has retreated 6%, while the S&P has been essentially flat.
Historically, small-company stocks have led the market in periods
of slower economic growth, but they fall behind when GDP grows by
3% or more, says Russell Investments, the keeper of the index.
Moreover, small-company stocks recently traded at an average P/E
that is nearly 110% of the 20-year average, while the P/E of
large-company stocks was 6% below their 20-year average.
Similarly, when economic growth lags, investors bid up the
stocks of companies--of whatever size--that have rapidly growing
earnings. So-called growth stocks have generally led the market
since early 2007, an unusually long cycle of dominance. But with
confidence in the economy improving, it makes sense to gravitate
toward stocks selling at bargain levels relative to earnings and
other traditional gauges of value. That means choosing shares of
) over Tesla Motors (
), International Business Machines (
) over Netflix (
), and Merck (
) over Regeneron Pharmaceuticals (
). So far this year, iShares Russell 1000 Value (
), an ETF that focuses on large, undervalued companies, has gained
3.9%, while iShares Russell 1000 Growth ETF (
) has gained 1.1%. "Rotation is the lifeline of a bull market,"
says veteran market analyst Ralph Acampora, of Altaira Ltd., a
money-management firm based in Switzerland. "As long as the money
goes somewhere else, but stays in the market, that's fine."
As you tweak your own portfolio, consider building some cash
reserves. In a shifting market it doesn't hurt to take some of the
money you've made off the table to be able to pounce on new
opportunities or if changes in your circumstances so dictate .
Sam Stewart, chairman of Wasatch Funds, has accumulated a little
more cash than he normally holds in the funds that he manages as he
prunes stocks he now considers overpriced from his portfolios.
"Choppiness is a reasonable forecast for the year," Stewart says.
"I want to make sure we have some dry powder on hand in case the
market does correct and we see companies we want to buy at
attractive prices." He says he will be looking for bargains among
technology, health care and financial firms--particularly those
that are lifting their dividends.
Stewart currently recommends shares in CVS Caremark (
) because he believes the corner drugstore is becoming more central
to family health care. Stewart also likes Wells Fargo & Co. (
), trading at a reasonable 12 times estimated year-ahead earnings
and yielding 2.8%. The bank navigated the financial crisis "just
fine," he says.
Let's just hope that investors will be able to say the same
thing about navigating the stock market this year.