Stocks: Will they bear up?

Experts think stocks are still your best bet, but gains may be less than in 2013

Stock investors cheered last year while bond investors groaned. Investment gurus generally expect to hear the same noises for 2014, although the laughing and moaning should be more subdued.

Expect a normal year for stocks, they say, with returns perhaps in the mid-to-high single digits. Expect a blah-to-bad year for bonds, especially the long-term variety, although the results won't be as dreary as the year gone by.

Those forecasts, of course, depend on the world going the way the smart people expect: moderate economic growth in the United States, low inflation and a modest rise in long-term interest rates — and without wars or another fiscal blowup in Washington.

This is "not an ideal environment, but one that should support further gains in stocks, and perhaps hints at a virtuous cycle of global growth that could be possible if the stars align," writes Russ Koesterich, global chief investment strategist at BlackRock.

Reality has a way of defying expectations. No one really knows what 2014 will bring.

Still, here are the best guesses from experts, along with some suggestions on how to play things this year.

THE ECONOMY: The consensus forecast among economists calls for gross domestic product growing 2.6 percent this year. That's moderate growth, and it's better than last year's weak performance, expected to come in at 1.7 percent.

But some think it could surprise on the up side. Bill O'Grady, chief market strategist at Confluence Investment Management in the St. Louis area, said he thinks it could hit 3.6 percent, which would be good news for stocks.

He credits the return of grudging cooperation in Washington, where Republicans and Democrats reached a budget deal. The result eased the federal budget cuts, which he believes shaved about 1 percentage point from growth.

The government will hit its debt limit again, probably in March, but there seems to be little appetite for another investor-frightening cliffhanger in Washington.

Consumers drive about two-thirds of the economy, and they are in shape to start spending again, if they want to. Debt payments as a percent of income are at the lowest point in 30 years. Unemployment, at 7 percent, is trending slowly downward. Confidence is up.

But the Great Recession taught us frugality. Consumer spending is rising moderately, but there's no sign of a spending spree.

STOCKS: Faster growth is good news for U.S. stocks. Stock analysts are calling for a 9 percent rise in corporate earnings this year. But such early forecasts are almost always optimistic. A 5 or 6 percent increase would be more likely, O'Grady said.

That ought to be enough to support a moderate rise in stock prices. Wells Fargo Advisors is on the conservative side, forecasting the S&P 500 at 1,900 by year's end, a mere 2.8 percent gain from 2013.

Joe Terril, who manages more than $500 million at his namesake investment firm in St. Louis, thinks prices might rise perhaps 7 percent. Add in dividends, and total return would hit 8 to 10 percent.

The more optimistic are counting on a repeat of a 2013 phenomenon called "PE expansion."

Basically, that means that stock prices grew faster than earnings. The big company stocks in the S&P 500 stocks started the year selling at 13 times earnings and ended up at 17.4. That's a hair above the 16.5 median for the last half-century.

"You don't get in trouble until it's just shy of 19," O'Grady said. "You can go above that if people really get optimistic."

Of course, that's not always the case. In the summer of 2008 — just before the big crash — it was at 17.8.

Take next year's more optimistic earnings forecasts, assume a PE of 19 and you get a nearly 20 percent increase in stock prices. Few if any are forecasting that.

The smaller stocks get, the more expensive they look. The small-stock Russell 2000 Index soared 37 percent last year. Its price-earnings ratio is now far above its long-term average, making them look pricey, according to Merrill Lynch. As a result, the big brokerage is telling clients to stick with big-company stocks.

Juli Niemann, analyst at Smith Moore & Co. in Clayton, Mo., is leaning toward midsize companies this year. "They grow up to be big boys," she said.

There is some broad agreement on the market's best sectors for 2014. Companies are sitting on lots of cash, and their order books are growing. Expect them to spend more this year on new equipment and other capital goods. That's good for technology and industrial stocks, according to Merrill Lynch. Materials firms also are looking attractive.

Wells Fargo Advisors adds consumer discretionary stocks to that list and warns to stay away from health care and utilities.

Dividend stocks, the heroes of 2010 to 2012, will lag because investors will be more growth-oriented, O'Grady said. "Utilities will probably suffer."

On Merrill's buy list are plane-maker Embraer, Ford, Express Scripts, FedEx, appliance-maker Whirlpool and energy firms Hess and Anadarko Petroleum.

Terril also likes Ford, despite the recent price dip. Ford cars are popular and the company has lots of cash. "They're making, long term, the right decisions, and I'm the patient type," he said.

Europe is finally, slowly, pulling out of its long recession. European stocks rose 18 percent last year, but analysts think they have further to go.

"European recovery is only just beginning, in our view, and the region is poised for a longer and more sustainable rally in the equity market in 2014," Merrill analysts wrote last month.

The emerging markets submerged last year, with stocks losing 7 percent of their value. Wells Fargo Advisors thinks they'll probably earn that back this year, but prospects are iffy. India, Brazil and China are going through economic reforms that could cause short-run disruption, notes chief international strategist Paul Christopher.

Emerging markets also are vulnerable to world capital flows. Better prospects in Europe and America, along with higher U.S. interest rates, could suck money out of the developing world. In all, investors' odds are better in richer countries, according to Christopher.

BONDS: Last year was generally stinky for bonds. The typical multi-sector taxable bond fund earned just 1.8 percent, according to Morningstar, while multistate municipal funds lost 2.3 percent.

Investors can blame the Federal Reserve for most of that. The Fed is "tapering" — gradually easing off its prodigious bond-buying, which helped keep long-term interest rates down.

As a result, analysts expect long-term rates to rise modestly this year. The 10-year Treasury rate may rise from last week's 3 percent to perhaps 3.25 or 3.5 percent, which is bad news for bond holders.

Bond prices fall as rates rise, and vice versa. The longer the term of the bond, the more the price moves with interest rates.

This year's tapering may set the stage for 2015, when the Fed may finally begin raising short-term rates as well. All of that means lean times for bond investors until the Fed is done.

Older investors remember the awful bear market in bonds that hit as inflation went wild in the 1970s and interest rates rose to double digits. Such a roaring bear is unlikely, O'Grady, given that inflation is a no-show and likely to stay that way. Instead, expect the modest rise in rates this year to sap bond prices, but not send them tumbling.

"Someday we'll have a bond market crash, but it will be after we are all dead," O'Grady said.

That reluctance to crash is a big reason to hold bonds: they help stabilize a portfolio. Stocks and bonds can move in opposite directions. Stocks lost 56 percent of their value between the fall of 2007 and March of 2009. Bonds gained 11 percent.

The upshot for investors: "I would not buy a bond fund," Niemann said. Individual bonds mature, and pay out their face value on maturity no matter what happened to their price in the meantime. But bond funds never mature, and their share prices fall when interest rates rise.

As an alternative to funds, investors can buy individual bonds and hold them to maturity. But many investors can't afford to hold enough individual bonds to spread the risk should one default.

Terril thinks bonds are bad, but he makes a limited exception for certain closed-end bond funds that trade on stock exchanges. They are selling at significant discounts to their net asset value.

"If someone is willing to sell me a bond at 87 cents on the dollar, I'll take it," he said. He suggests Aberdeen Asia Pacific, PIMCO Dynamic Credit, Nuveen Preferred Income and BlackRock Build America bond funds.

Unlike other mutual funds, these closed-end funds borrow money to invest, which can increase both return and risk.

Meanwhile, a round of rotten publicity is adding to the woes of the muni market. Detroit became the biggest town ever to go broke, and it wants bondholders to take pennies on the dollar.

Despite that, analysts note that muni defaults are still rare: Fewer of them occurred last year than in 2012. But fear is weighing on the muni market. "Detroit just scared the heck out of everybody, and that's going to continue," O'Grady said.

COMMODITIES: Stay away from commodities, analysts say. Oversupply will keep prices weak in 2014. Meanwhile, a recovering economy has tarnished gold. Its price dropped 28 percent last year. Gold shines when economies and currencies are collapsing or inflation is soaring. In good times, it's just a pretty metal.

What could put the lie to all these forecasts?

Interest rates are the biggest worry, analysts say. They are notoriously hard to forecast. If they rise sharply, they could slow the economy, make stocks look pricey, and make suffering bond holders suffer more. More craziness in Washington, or a war scare could also sour the markets.

All that is giving analyst Niemann a new respect for cash, especially as an alternative to bonds. You'll lose a little to inflation, but it's handy to have around when nasty stuff happens in the markets.


"There's no risk in cash, and you're not earning a lot less than in the bond market," she said.


Reader Reaction
We reserve the right to remove any content at any time from this Community, including without limitation if it violates the Community Rules. We ask that you report content that you in good faith believe violates the above rules by clicking the Flag link next to the offending comment or fill out this form. New comments are only accepted for two weeks from the date of publication.
COUPON OF THE WEEK