WALL STREET: ANOTHER GOOD YEAR FOR U.S. STOCKS CONTRARIANS SEE RISKS FROM STRETCHED VALUATIONS, INFLATION AND THE FED

Bank strategists agree:   U.S. stocks are going up in 2014, at least a bit. At the beginning of January, after the Standard & Poor’s 500 Index closed out 2013 at 1,848, their end-of-year targets ranged from 1,850 to 2,100. The median among 20 sell-side prognosticators was 1,950, which would be a 5.5 percent gain if it pans out. In other words, after big advances for U.S. stocks in four of the past five years, including a robust 32 percent return for the S&P 500 last year, the forecast is for more.  

What could possibly go wrong? Fortunately, there are always a few money managers and strategists ready to address that question. Their present concerns encompass inflation, Federal Reserve tapering, stock valuations and technical chart breakdowns. 

David Rosenberg, chief economist at Gluskin Sheff & Associates Inc., says the biggest stock market risk right now is that the Fed will be forced to raise interest rates as the economy grows faster than expected. That flies in the face of current wisdom. While the Fed has begun to withdraw its monetary support for the economy by trimming its bond purchases, most economists say the central bank will keep its benchmark funds rate near zero at least into 2015.  

A market that shrugged off bad news for the past several years may quickly become one underwhelmed by good news, in Rosenberg’s thinking. “One thing that we learned in this cycle is that you can have very weak growth but a tremendous surge in the market when the Fed is providing a tremendous amount of liquidity,” he says. “I’d expect that when we actually get growth, and we get the Fed doing something different, we’re going to get different results in the market.” 

Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, describes a scenario that has a lot in common with Rosenberg’s. Inflation, or inflation fears, is a possibility in 2014, Paulsen says. He sees nominal economic growth accelerating to as much as 6 percent with gross domestic product expansion at 3.5 percent plus inflation, measured by the GDP price deflator, up to 2.5 percent.  

The threat of an overheating economy would then raise concern that the Fed will be unable to withdraw its extraordinary monetary support in an orderly fashion, Paulsen says. “The methodical and well-controlled monetary tapering which greets us here at the beginning of the year could turn to a ‘panic taper,’” Paulsen wrote in a Jan. 2 letter to clients. That would wreak havoc in the bond market, and    boost stock market volatility, he says.  

Paulsen forecasts that the S&P 500 will climb as high as 2,000 at some point in 2014, a gain of 9 percent from when he published his note, and then slide, finishing with no gain at all for the year. If that comes to pass, it likely would be a setback and not an end to the bull market, which he says has more years to go.  

Sam Stewart, chairman of Wasatch Advisors Inc. in Salt Lake City, predicts a rapid stock market sell-off at some point in 2014. He argues that stock valuations are stretched after the five-year bull market, especially when rising price-earnings ratios are compared with slowing growth rates the so called PEG ratio. Based on profits and profit growth for the most recent 12 months, the S&P 500’s PEG ratio was    3.1 at the beginning of the year, compared with a 20-year average of 1.1, according to Stewart. That’s higher than it was in 2007, when the market touched its pre-financial-crisis peak, he says. 

price earning ratio
source : yale university

If stocks are expensive, they’re vulnerable to unpleasant surprises, Stewart says. The nationwide steel strike in 1959 and the failure of Long Term Capital Management in 1998 are examples of events that triggered selloffs in overvalued markets, according to Stewart, whose Wasatch World Innovators Fund beat 99 percent of its peers during the past five years.  

For Carter Worth of Oppenheimer & Co., the New York investment bank and wealth manager, the big risk may be simply that total returns for U.S. stocks have been positive for five years running. Worth is his firm’s chief market technician, meaning his forecasts are based on historical charts and patterns, not economic or company fundamentals.  

Since 1927, the S&P 500 has had five consecutive winning years on six previous occasions. The average return in the next year was negative 2.3 percent, according to Worth. And the peak-to trough decline in that sixth year, as opposed to the calendar year move, averaged 23 percent. “At a minimum, 2014 has high odds to be a below-average year,” Worth says, “with the possibility that it’s not only below average but has something quite ugly.”