Stocks poised to climb higher

- John Stephenson, CFA

After the banner finish to the market last year, the price action on the S&P 500 has so far been somewhat dismal with stocks consolidating and digesting their big advance.

Most of the trading so far this year is coming from fast money hedge funds, with big mutual fund investors choosing to sit this round out.Markets are searching for a direction in the early part of 2014, and there doesn't seem to be a lot of conviction on the part of investors.

Adding to the recent skittishness was the December payrolls shocker that showed the weakest pace of hiring in three years. American employers added just 74,000 positions in December, a disappointing turn after a four-month stretch over which monthly payroll expansion averaged gains of 213,500.

But for now, investors seem to have decided that the most recent payrolls report was more confusing than disappointing, with many believing that the poor results were either due to weather or a statistical fluke, rather than a sign of underlying economic weakness.

The market's performance in 2013 was impressive, with all ten S&P 500 sectors posting gains. Cyclical sectors were the place to be last year, while defensive sectors lagged the market.

The Consumer discretionary sector soared 41 per cent. Health Care stocks were up 39 per cent, followed closely by Industrials (+38 per cent), with Financial sector stocks finishing up 33 per cent on the year.

The good news wasn't limited to America as Germany's DAX index soared 26 per cent in 2013. Japan's Topix, meanwhile, rallied 24 per cent in U.S. dollar terms.

But it was a different story for the emerging markets. Turkey fell 28 per cent, while Indonesia and Brazil slumped 25 per cent and 19 per cent, respectively, as higher bond yields and a stronger U.S. dollar took their toll on these markets.

The few bright lights in emerging market performance were from China, which eked out a modest gain of 0.4 per cent, while Korea was up just 2.7 per cent and Taiwan finished the year up 6.6 per cent.

Merger and acquisition activity was strong last year, rising by four percent despite the weakness in mining and energy deals. The most active sectors for deals were in real estate and telecoms, with the average takeover premium hitting a record of 25 per cent.

Commodities struggled again in 2013 with mining stocks such as precious metals spiraling downward as gold fell 28 per cent and silver tumbled by 36 per cent.

Bubble Trouble?

The strong performance of developed markets in 2013 has some investors beginning to sound the alarm. Many are suggesting that the strong advance of the market over the last few years is reminiscent of the late-1990s tech bubble.

Adding fuel to this fire is the release of the minutes of the latest Federal Reserve policy meeting, which show that central bankers too are concerned that financial markets may be entering bubble territory.

It's getting harder and harder to open a newspaper or turn on the financial news these days without some financial commentator suggesting that a bubble is upon us.

While today's stock market may not be a bargain, it doesn't appear to be anything like the overhyped market of 1999-2000. For starters, retail investors have been sitting out most of this recent rally, with equity allocations some 20 per cent below the peak of the late 1990s.

Despite the slow start to 2014, I expect the year to be a pretty good one for equity investors

There's no prevailing view by retail investors today that the world is being swept up by some irresistible force that makes stock investing a no-brainer.

The psychology is very different this time around, as investors have witnessed two major bear markets in the past decade as opposed to the late 1990s, which marked a twenty-year run for stocks.

Reasons for optimism

Despite the slow start to 2014, I have a positive market outlook for equity investors. I see U.S. 10-year yields hitting 3.5 per cent by year-end, which should help drive fixed-income investors toward the market.

The U.S. economy should be able to grow at three per cent or more this year, the best performance in a decade, which should bolster sentiment and equity flows. The threat of tapering has finally caused investors to withdraw money from bond funds, and equities have witnessed very significant inflows year-to-date.

Falling correlations between assets as the stock market transitions from being policy-led to fundamentally driven will be good news for active managers who have taken a backseat to passive strategies the past few years.

My current market forecast for the S&P 500 is for the index to exit 2014 at a target of 2,100.

Part of the reason for my bullish forecast is that domestic and global indicators are pointing to an improvement in the U.S. economy.

Historically, every one per cent change in nominal GDP drives roughly a two and a half per cent change in S&P 500 revenues. With U.S. economic growth expected to be more than three per cent this year, earnings growth should be substantially higher than the current bottoms-up forecasts of equity analysts.

The Federal Reserve is likely to remain extremely accommodative, which will help to act as a tailwind to equities. This is the slowest recovery in the post-war period, progressing at half the normal pace, which has resulted in excess capacity across the economy and very little inflationary pressures.

Since inflation is well-below the Fed's two per cent target, and there's plenty of slack in the labor market, the Fed will be spending most of 2014 on the sidelines.

Piles of cash

North American companies are sitting on record levels of cash, but they've been quite reluctant to make longer-term capital commitments. This frugality should benefit investors in the form of earnings per share growth via margin improvements and share buybacks.Despite worries about the possibility of rates backing up and the subsequent impact on stock market performance, history has shown that periods of modest interest rate back-up are good for stocks.

Not only that, but I believe the relationship between corporate bond yields and equity valuations remains distorted. U.S. corporate bonds imply a price-to-earnings multiple of 18.6 times, while stocks trade at 15.3 times. Ultimately, this gap should close.

I am favoring developed markets over emerging markets for the next six months or so, as monetary policy and earnings revisions are supportive for these markets. Investors should continue to overweight cyclical stocks that will benefit from solid economic growth.

For my money, I like the financials, health care, industrials and tech stocks, as they are sectors that tend to benefit from an uptick in economic growth.

Sectors to watch

With forward-looking economic indicators such as the Institute for Supply Management data, and new orders picking up, economists are more bullish than sector analysts as the market is poised to move higher.

Industrial companies in the U.S. should do well, given their 40 per cent foreign sales exposure with the improving macroeconomic conditions in Europe and Asia.

Financial companies will be driven by strengthening loan volumes and improving credit conditions as well as rising real estate values, which are ultimately leading to reserve releases (dividends and share buybacks).

Obamacare should continue to drive increasing volumes in 2014, which will result in higher revenues for the healthcare stocks group than any of the other non-cyclical sectors. Biotech looks particularly attractive relative to Big Pharma on growth and valuations.

What I recommend

One name that I really like is Gilead Sciences (NASDAQ-GILD, $74.77). The company is a research-based biopharmaceutical company that discovers, develops, and commercializes therapeutics to advance the care of patients suffering from life-threatening diseases.

The company's primary areas of focus include targeted therapies for HIV/AIDS, liver disease and serious cardiovascular and respiratory conditions.

* My Advice: I have a buy rating on Gilead and a 12-month target price of $100 per share.

Wells Fargo & Co. (NYSE-WFC, $46.69) is a diversified financial services company providing banking, insurance, investments, mortgages, leasing, credit cards, and consumer finance. The company is led by a shareholder-driven management team that has consistently delivered superior returns from its well-diversified business model and attractive franchise that now runs coast-to-coast.

Wells Fargo should be able to deliver above-average growth primarily through market share gains and increased cross-selling of both its legacy Wells and newer Wachovia customers. With credit conditions improving, I see further declines in provisions which should help drive EPS growth.

* My Advice: I have a buy rating on this stock and a 12-month price target of $52 per share.

Vertex Pharmaceuticals (NASDAQ-VRTX, $70.20) is a biotech firm that was founded in 1989 with an explicit strategy of rational drug design rather than combinatorial chemistry.

The company has focused its pipeline on viral infections, inflammatory and autoimmune disorders and cancer. The company has several milestone opportunities this year that have the potential to boost the share price.

* My Advice: I have a buy recommendation on the stock and a 12-month price target of $105 per share.

The Bottom Line

While it's hard these days to find someone cheerleading the market higher, I believe that 2014 represents another great year for investors.Valuations are somewhat higher than the long-term average, but there appears to be an absence of irrational exuberance in the marketplace.

Investors are still licking their wounds from 2000 and 2008 and are exercising reasonable caution in their approach to investing.

Bond investors experienced their first losing year since 1999 last year and are finally beginning to realize that the best opportunities for investment success are in stocks.

I believe that the markets will move higher in 2014 based on stronger than expected growth and earnings.