5 lessons this year's market holds for 2014

With 2013 coming to an end, it may be a good idea to heed these tells as you prepare your playbook for next year.

By StreetAuthority Nov 7, 2013 3:54PM
Office worker marking calendar with red pen © Image Source, Image Source, Getty ImagesBy David Sterman                                                                       
Happy days are indeed here again.

The stock market rebound that began in March 2009 has proven to be remarkably durable.

While many thought the bull needed a breather after rising at a double-digit clip in 2012, it has actually grown stronger: Even with a series of boulders thrown in its path, the S&P 500 Index has tacked on 20% gains thus far in 2013, which is surely higher than even the most bullish forecasts had  anticipated when the year began. 

Credit goes to a "goldilocks" market backdrop, as the U.S. economy is just strong enough to deliver corporate profit growth but not so hot that the Fed looks to apply the brakes to its massive monetary stimulus program.

But after years of market gains, should you become complacent? History says its wise to book profits whenever all of the market's stars are in alignment. The "Wall of Worry" that investors had to climb in recent years has been scaled, and even short sellers are afraid to bet against this market right now.

For people like Warren Buffett, a steadily expanding bull market can lead investors to the wrong conclusion: "Once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks." He said that back in 1999. 

But simply hitting the "sell" button is also unwise. In some respects, the drivers of upside in 2013 remain in place, and may power stocks higher in 2014 as well. Yet you need to dig into then factors behind this rally to help draw your own conclusions. A look at why the market is reaching new heights can give us a clear read into what to expect in the year ahead.



Here's a look at five key themes from this year, and what to expect in 2014.

1. The Fed's long-awaited tapering
For the past six months, the Federal Reserve has inched ever closer to ending the massive quantitative easing (QE) program that has pumped $85 billion into the economy every month. The Fed seemed poised for an imminent move in the spring, which led the markets to slump in late May and early June. The fact that Fed decided to wait a bit longer led investors to conclude that it was still safe to buy into a liquidity-fueled market.

Few have expressed concern that the Fed's inaction is the result of an economy that just can't build a head of steam. Perhaps the fact that the economy is at least maintaining modest growth -- and not showing signs of a fresh recession -- is seen as a source of comfort.

Still, the end of QE is inevitable, with consensus expectations that the Fed will shift gears at the Federal Reserve Open Market Committee (FOMC) meeting held on March 18-19, 2014. If that happens, then stocks could start to slump in advance. As we saw last spring, investors began to sell stocks when they sensed that QE would soon end.

2. The yield 'head fake'
Ahead of an expected Fed move this past spring, income-producing stocks began to take it on the chin, as the yield on the 10-year Treasury rose a full percentage point. Investors figured that rising interest rates, which would be one of the corollary impacts of the end of QE, would make dividend yields comparatively less appealing. Short sellers even began to place significant stakes against high-divided stocks and funds.

Of course, with the Fed never actually making a change, the yield scare eventually cooled down, leading these same short sellers to cover their positions against income-producing investments. But we now have a market tell: Once the Fed decides to act, dividend-paying stocks are again likely to rotate out of favor.




3. Emerging markets: risk-on/risk-off
Investors fled emerging markets in droves this summer, as fears as falling Fed liquidity in the U.S. (with the end of QE) would cause a cash crisis in many countries that ran high trade deficits.

Yet as I noted back then, "the sharp pullback in places like Brazil, Australia, Turkey and elsewhere should be seen as opening for investors that have been awaiting better valuations in these markets."

Well, emerging markets have subsequently posted nice gains, with many of the exchange-traded funds (ETFs) rising 10% to 20% since the summer swoon.

The recent rebound for these funds, coupled with the fact that the Fed will eventually come back to spook global investors, means investors couldn't be blamed for locking in profits. I remain very bullish about emerging markets for the long haul, but there are continued signs of distress in places like Brazil, Turkey and Indonesia. I love where these economies will be in 10 years, but investors should brace for anemic economic growth rates in 2014.

4. The oil gusher could really play out in 2014
Over the course of 2013, the U.S. has been steadily and rapidly expanding domestic oil production, consuming fewer oil imports with each passing month. The fact that our nation's automobiles are ever more fuel-efficient also changes the global dynamics for oil supply and demand.

Still, oil prices stayed firm this summer as West Texas Intermediate Crude (WTI) remained above $100 a barrel. It seems as if reality has finally begun to set in. Crude prices have dropped more than 10% over the past six weeks, and recent inventory trends imply further drops ahead. According to The Wall Street Journal, "Total (crude oil) stockpiles of 383.9 million barrels are at the highest level since late June and the highest amount since the Energy Information Administration began tracking the data in 1982."

Falling crude oil prices are providing badly needed relief for consumers, as gasoline prices have fallen to 11-month lows. Airlines will also feel relief from lower jet fuel prices, and home-heating bills this winter could also get a break.

Notably, the U.S. energy sector has plans for big output gains in 2014 and 2015 as well, and a year from now, we may be talking about $70-a-barrel crude oil.

5. Small-cap biotechs are imploding
Investors embraced biotech stocks in a big way in 2012 and much of 2013. But in recent months, the large-cap biotech stocks (such as Celgene (CELG), Gilead Sciences (GILD), Amgen (AMGN) and others have continued to bounce near all-time highs, while dozens of smaller biotechs are now in the midst of a deep slump.

Why the dichotomy? Because these smaller biotechs are often cash-starved. And in the financial crisis of 2008, they failed to shore up their balance sheets in time and had to endure massive dilution to reload with cash.

Investors are clearly again concerned about cash-burn rates, though it's not fully clear that the current era holds great parallels to 2008, when the capital markets were slammed shut. Still, before you buy that next biotech, make sure it has enough cash on hand to cover 24 or even 36 months of clinical trials.

Some of my favorite small biotechs that have recently sold off but have ample cash on hand include:

Threshold Pharma (THLD)
Dynavax (DVAX)
Regulus Therapeutics (RGLS)
Synergy Pharma (SGYP)

All of these biotechs are far from their 52-week highs but are expected to make clinical trial progress in 2014.

Risks to consider: The real risks for stocks in 2014 are the ones we can't see. It likely won't be a Washington-induced mess or a fresh crisis in Greece. Investors are already desensitized to those threats. Instead, it's the "unknown unknowns," as Donald Rumsfeld would say, or the "Black Swans" that Nassim Taleb would mention.

Action to take: Here's a bold prediction: The market won't rack up the gains in 2014 that it has in 2013. There are limits to how far this Fed-induced liquidity rally can go, and unless corporations can markedly expand profit margins from already high levels, then corporate profit growth is likely to be too anemic to justify much more upside.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.
 
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5Comments
Nov 7, 2013 10:20PM
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Interesting article.  #4 with dropping oil prices is probably the least talked about factor that could really give us a boost.

I'll disagree that the real risks for 2014 are the ones we can't see.  The ones we can see are potentially devastating.  Remember the debt ceiling and budget battle?  That smacks us in the face early in the year.  Then we've got to deal with Yellen and a more hawkish Fed and tapering will be on the mind of everyone.  The fallout from Obamacare is still in its infancy - there will be plenty more "unintended" and negative consequences next year.  And don't forget, 2014 is an election year. 

But there is some potential good news, at least for investors, at least temporarily.  Ultimately, we could see the election used as an excuse to push all of these issues to the back burner and into 2015.  It might sound far fetched to think of QE as extending into Q4 of next year, but just look at where we've been, it's really not that improbable at all.  Politicians are infamous for kicking the can down the road, especially in an election year as most of them are cowards and afraid of alienating any segment of their constituency.   The same also applies to Obamacare - it will inevitably be delayed as the politicians turn their attention to winning an election.

Nov 8, 2013 10:24AM
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 "disagree that the real risks for 2014 are the ones we can't see.  The ones we can see are potentially devastating.  Remember the debt ceiling and budget battle? "

 

That's been said for the past 50 years. What else is new ?

Nov 7, 2013 7:36PM
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Excellent  well balanced insightful article. Agree 100% on outlook for 2014.
Nov 8, 2013 5:23AM
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Predicting the Markets won't do as well in 2014 is hardly a Bold Prediction. Nor are investors desensitized to fresh crisis like Greece, if they flare up again, so will it's effects. There are very little unknowns unknowns short of a Super Volcano eruption or a Asteroid Strike type event. Everything else is pretty much KNOWN. The REAL Risks for 2014 are the very ones we can see, many of which didn't go away and some only likely to get far worse.

1)$500-700Trillion in Global Scam Derivatives
2)Rising Interest Rates
3)Soaring Global Government DEBT
4)Soaring Corporate Debt(used for Stock Buybacks)
5)Student Loans
6)The China Black Hole
7)Record Stock Margin Debt

These just to name a few. To taper or not and it's effects, mostly guesswork as there are no time machines to prove whether or not the Markets would have reacted as many have suggested if Taper was severely cut. People always assign blame to why Markets go down but rarely is there Real Proof that was the sole reason or the Real Reason. The Feds actions are the convenient excuse for latest ups or downs in the Markets. Remove that as a factor an folks will find another convenient excuse for why we have ups and downs in the Markets. That has been the case for Decades.

Nov 7, 2013 6:27PM
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Always a pleasure to read Mr. Stermans' articles. Nicely written and seem well thought out. Keep up the good work !
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