After going lower during the first two weeks of December, the market has really made amends for this transgression as it has now risen during the last two full weeks of the month and the S&P was set to close out 2013 with its best performance since 1997 by gaining 29 percent. That advance from December 13 through December 27 was the best two-week gain since July, and resulted in a 3.7 percent price rise. As a result, the month of December has now produced a 1.9 percent S&P gain which moves this year ahead of the traditional advance for the last month of the year of 1.5 percent. This record of advances makes it the second-best performing month of the year and compares to the average gain of 0.6 percent for any month since 1928. The 29 percent gain this year would be the 13th-best yearly performance since the advent of this index in 1928, so the year just ended has certainly been one for the record books.
The Federal Reserve’s decision two weeks ago to begin the tapering process of its $85 billion a month of bond purchases by $10 billion a month starting in January was accompanied by its pledge to keep the federal funds rate (at which banks borrow from each other) at or near record lows even if the unemployment rate falls below its target of 6.5 percent.
This decision has turned market psychology around in the sense that now good news is treated as good news instead of bad news for fear of a negative market reaction to the Fed pushing that tapering button. And this past week, even though the number of economic reports was light, saw November durable goods orders rise by 3.5 percent, more than expected; November new home sales decline from October’s highest level since July 2008 and November pending home sales rise for the first time in six months.
Market gains have also been a function of $162 billion being put into equity mutual funds and exchange-traded funds, which was the largest such inflow since 2000. This has helped the market to its fourth consecutive monthly advance in December as well. And to make matters more appealing for the bulls, the Dow Jones Industrial Average notched its 51st record high on Monday at 16,504. The S&P has achieved this distinction on 44 occasions in 2013.
And for those who want to be optimistic going into 2014, let it be pointed out that the S&P has ended higher almost two-thirds of the time in the year following a gain of 25% or more in the prior year, which is what the market accomplished in 2013.
It is quite conceivable that the new year can continue the upward trend of the year that just ended as the upbeat mood of consumers and the housing recovery can both extend themselves. Companies are flush with cash to the tune of $1.8 trillion, which would allow them to continue share buybacks and dividend increases, both of which have gained at record levels. Earnings growth for 2014 is projected in the 5 to 7 percent range. There is also $10 trillion in money market and cash accounts earning next to nothing, which could finally force those people into equities in search of higher returns.
The market’s forward price/earnings ratio has reached around 15, which is an improvement from only 13 at this time last year, which indicates that investors believe that the financial crisis of five years ago is finally over. If these multiples expand to more normal historical levels of around 16, stocks would be given an additional boost.
Also putting investors’ minds at ease has been the largest decline in gold prices since 1981, which was the first annual drop in 13 years. Interest rates have been rising as well, as the yield on the 10-year Treasury note reached 3 percent from its all-time record low of 1.62 percent back in the middle of 2012. This should not be construed as negative, because instead of being a cause for worry, these interest rate increases are representative of an improving economy with greater demand for credit.
With all of this optimism around, additional market gains in 2014 are by no means a certainty, as there are factors that could work against equity prices. The greatest danger could be a rise in inflation caused by stronger economic activity, which could force the Federal Reserve to raise interest rates sooner than their current pledge to keep them at current near-record lows until at least the end of 2015. Rate increases of this sort have been responsible for large market declines in past years, and this would appear to be the primary potential impediment for stocks going forward.
There is also the concern that overseas economies could run into difficulties, as China’s recent decision to allow short-term interest rates to spike higher has the potential to result in some sort of contraction in the world’s second-largest economy. Japanese sales tax increases enacted for 2014 could pressure consumer spending there, although the decline in the yen to a five-year low against the dollar should conceivably revive their export sector.
Europe has shown signs of coming out of its long slump, but the recent strength of the euro might slow the export potential of the largest economy in the region, Germany. Finally, there is always the potential for some kind of unforeseen geopolitical event to upend equity markets as well. Such world trouble spots as the ongoing civil war in Syria, with no end in sight, could result in other countries in the region getting drawn in to a greater extent than they have and might result in an oil-price spike.
The Turkish economy has been in a crisis due to anti-government demonstrations that have led to a weakening of their currency to a record low against the dollar and an 18 percent decline in their stock market this year.
This does not mean, of course, that any of these scenarios are about to develop in 2014, but the potential for some kind of unforeseen event is always out there, especially considering the elevated level of the stock market after the 170 percent advance off the March 2009 lows.
Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media.
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