Don't expect a bull market in 2014

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Chances of a stock market pullback in 2014 are high. A long run of positive returns without historical precedent and a stalling of corporate earnings growth are two reasons why markets may slow down next year.

So far in 2013 the S&P 500 is up about 23%, and volatility has been very low. A possible Fed “tapering,” a government shutdown, and the imminent threat of a US default did little, if anything, to derail this stellar performance which stands out in equity market history.

According to more than 140 years of data compiled by Prof. Robert Shiller of Yale University, a positive year for stocks follows a negative year (or vice versa) about 50% of the time. Two, three or four up- or down-years in a row are progressively less common. Five-year streaks are quite rare, happening only 4% of the time. And there is only one 6-year streak recorded, from 1897 to 1902.

If 2013 ends on a positive note, as it seems almost certain, it will mark one of those rare 5-year streaks (2009-2013) closely following another (2003-2007). And this is where the warning lights go off.

With this performance, 2013 will mark the first time in history when US stocks go up 10 out of 11 consecutive years. And if stocks go up again in 2014, it will be the first time they climb 11 years out of 12.

Another way of visualizing how stretched the stock market has become is by plotting consecutive 5-year S&P 500 returns along a line. The historical 5-year return average is 31%. Assuming that the S&P 500 ends the year at around today’s level (1760), the five-year 2009-2013 return would be over 100%, which is higher than three times the historical average. This is an event with a measly 4.3% probability of occurring.

Stock market 5-yr returns stretched too thin

Graph source: Path Financial LLC

To be sure, just because the stock market never went up 11 years out of 12, it doesn’t mean it can’t. Return streaks do not explain whether the stock market is fairly priced or not. But it is important to realize that expecting stocks to go up again in 2014 is equivalent to expecting an outcome that has no precedent in US stock market history. For it to happen, major forces would have to push it in that direction.

But it’s difficult to find such forces today.

According to Factset, stock prices seem to have sprinted ahead of both trailing and forward earnings (see graphs). Without the earnings impetus, it is hard to see how stock prices can continue to climb.

Stock market price vs. 12-mo forward EPS

Stock market price vs. 12-mo trailing EPS

Graphs source: Factset

In addition, Washington is scheduled to rehash partisan budget and debt battles in the first quarter. Although the stock market proved resilient this year to congressional theater, the regular introduction of uncertainty in the world economy may start to have more serious consequences on prices, especially at a time when valuations seem stretched.

It doesn’t take a major fall in equity indices to correct any of these imbalances. In fact, a minor retracement in the S&P 500 would go a long way towards fixing them. The danger may lie in the high-flying stocks that took off this year, as even a small contraction in the major indices can trigger a large fall in stocks that are highly sensitive to sentiment.

The outlook for 2014, therefore, appears to be unfavorable for the kind of equity appreciation we have enjoyed in recent years. While this may simply mean that stocks could just break even next year, enough factors suggest that investors may want to cash out of their more aggressive holdings.

What now?

We use quantitative measures to build and maintain dynamical multi-asset portfolios for our clients. Our process aims to identify when to buy or sell different asset classes, with a focus on avoiding extended losses, seeing through the haze of very short-term volatility, and looking at what securities are priced favorably at various times in the investment cycle. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment process can work for you. We’ll be happy to set up a confidential meeting to discuss your path to financial success. Read more