2014: What to Expect

With US markets having such a great and essentially uninterrupted run this year, many are under the impression we shouldn’t expect too much from the S&P next year. History tends to argue against that impression as market strength begets more market strength on average. However, this doesn’t mean everything will be completely hunky-dory in 2014… even though most great years in the S&P are followed by good years, those good years tend to have their share of pullbacks. Check out this chart from S&P Capital IQ:

According to history, the average performance of a year after one like 2013 is greater than the historical average return of the market. The market is up 78% of the time in this scenario, but every one of these years has experienced a drop of at least 6.2%. The odds are positive if you are long the market, but don’t expect volatility to completely die out. There are plenty of things to worry about in 2014: our government continuing to be dysfunctional, FED Tapering, and a decline in profits as a % of GDP from their all-time highs. While the first two scenarios are expected by just about everyone, the third is not.

Through a combination of higher wages, stronger hiring, and stronger GDP growth, I would expect margins and profits/GDP to drop. This doesn’t necessarily spell doom for stocks, but it could cause a short-term pause or pullback if investors have to digest a weak quarter or two of earnings. I would actually view it as a long-term positive as it will allow demand and sales to grow as workers receiver higher compensation and more people enter (or re-enter) the workforce. The fact that productivity growth has slowed to a meager pace since the end of 2009, I believe businesses have pushed their employees to the limits of their potential and will have to hire to continue expanding.

Once investors realize that this drop in profits/GDP is due to a growing economy and not due to an impending recession, the secular bull market should continue. 

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