In this third and final commentary regarding market trends and prospects in 2014, I would like us to concentrate on what we assess to be key-elements for equity markets as the New Year unfolds. But first, a word on bonds: Like last year, we anticipate that the sovereign bond market to go sideways in 2014 and possibly to exhibit negative returns again as interest rate normalization goes underway. For fixed-income investors we feel more confident about corporate bonds which could also include some exposure to high yield bonds. Overall, and unless someone is fascinated by the liabilities that bonds represent, we would not suggest any exposure more than 20% in the overall debt market.

Here are the additional overall fundamentals (macro and micro) that make us optimistic about equities in 2014 (see also the Dec. 12th, 2013 commentary):

• We expect economic growth to exceed 3.2%.
• Fed’s tapering would signal continuous strength in the economy
• Global developed markets would get into a synchronization mode as far as trends are concerned
• There are values in the corporate world (see points on IPRI and P/E ratio below)
• Single market tools – as all tolls used – are fallible. Incorporating risk into perspective (which perspective is an incomplete measure of perception) can be very valuable though if used along with other measures. The IPRI (Intermediate Potential Risk Indicator) does exactly that. The IPRI quantifies the market risk by focusing on the number of NYSE stocks that trade above their 200-day moving average. When that percentage starts exceeding 75%, bubbles are being formed and a downtrend may be starting. The IPRI currently stands below 60, and thus allows room for further expansion.
• Expanded liquidity forms a dynamic of pullbacks in the neighborhood of 4-5% (when bad news hit the market) that become stepping-stones for further equities’ gains. Those pullbacks are necessary for the sustainment of a bull market
• A stronger dollar would attract capital to the US while advancing exports of other countries
• Subdued commodity prices allow the supply chain to experience an expansionary cycle
• The tendency to increase dividends will keep shifting funds from bonds into equities
• The buy-back programs of several corporations (using abundant cash that they hold) point to a confident environment by executives and boards (of course this could be part of the artificial market boom that focuses on perceptions’ formation. However, no matter what the motive is the outcome would be higher stock prices)
• Increased capital expenditures (currently at 13% of GDP vs. an historical average of 18%) would pave the way for higher future earnings which the market tends to discount early on
• There are still stocks (especially in the technology sector) whose price-earnings ratio (P/E) is significantly lower than the market’s average. Moreover the technology sector exhibits a 22% return on equity (ROE) vs. the 15% ROE for the S&P 500
• Capital expenditures will advance technology stocks which will signal a wave into higher risk-taking in an environment of rising bond yields (the latter may hurt those equities that act as bond proxies)
• Stronger real estate activity will boost employment prospects and nonresidential real estate is destined for a good year
• The government cutbacks will be of a lesser drag in 2014, while the improving economy will lead to a lower fiscal deficit

Now, as for the dangers awaiting us we could state the following:

• Interest expenses and taxes are expected to rise and thus cut into the EBIT (earnings before interest & taxes) projections
• Rising yields and Fed’s missteps could ignite a pullback or a series of pullbacks greater than the expected one (see point above) which in turn could ignite a significant correction
• A Chinese hard landing due to local credit and bank issues could unravel the markets
• A re-ignition of the Euro zone crisis could also turn things upside down
• An Argentinean foreign reserves crisis could unsettle emerging markets and start a crisis of confidence
• Geopolitical and purely political events have the potential of altering the market’s upward trend
• The fact that the market for nearly two years now has not experienced a serious setback could by itself be a cause of concern
• Historically speaking bull markets that last four-five years eventually are knocked off due to recessions
• While it might be premature to start thinking of a rogue wave (a.k.a. in oceanography as monster killer wave) I believe that the concerns expresses by the late Chairman William McChesney Martin in the imaginative dialogue discussed in the December 29th commentary, should form the basis of serious thinking if the attempted collateral assets surgeries fail. In such a case, around 2016 we could witness a point of no return when a rogue wave – formed by the merger of economic headwinds and debt currents – start turning things upside down

Our best wishes for a profitable New Year.