As we near the halfway mark of 2014, the bull market isn't over -- but expect a choppier ride ahead. Large, economically sensitive companies are poised to benefit.
Remember when you were younger, full of exuberance and able to jump higher and run faster? Was it only last year that a charging bull delivered a 32 percent return to investors in the U.S. stock market?
In our January issue, we predicted that the S&P 500 would finish the year in the vicinity of 1,900, and the Dow Jones Industrial Average ($INDU +0.02%) would close above 17,000. At midyear, we still think that's a good, conservative bet, although it's possible that stocks could tack on a little more -- with the S&P closing between 1,950 and 2,000. That would produce gains of 6 percent for the year and would translate to roughly 17,500 for the Dow.
Stock returns will mirror growth in corporate earnings, which analysts estimate at 6 percent to 7 percent this year. Dividends will add another two percentage points to the market's return.
But the market has grown more complicated, with a lot going on beneath the surface. The tide is no longer lifting all boats -- in order to prosper, you'll have to be choosier about where you invest. Many of yesterday's market leaders are becoming today's laggards, making for choppier waters overall.
In general, we think the rest of the year will favor larger companies over smaller ones; companies that sell at reasonable values over high-growth, high-priced stocks; and companies that are more sensitive to improvement in the economy than those considered more defensive. (All prices and returns are as of April 30.)
Five-plus years into the bull market, "2014 will be a big test," says Matthew Berler, co-manager of the Osterweis Fund. Investors will grade the bull on how well it manages some midlife crises -- or, if not crises, at least challenges.
Readying for higher rates
The bull's first challenge will be making the transition from a market driven by super-easy monetary policies and little competition from fixed-income investments to one more focused on corporate profits.
The Federal Reserve is unwinding its bond-buying program aimed at keeping long-term rates low and will eventually look toward raising short-term rates, most likely next year. As investors begin to anticipate that tightening, the market could suffer a 5 percent to 10 percent pullback, perhaps in the fourth quarter, says David Joy, chief market strategist at Ameriprise Financial. But if raising interest rates to a more normal level is seen as a vote of confidence in the economy, as he suspects will be the case, then it won't be the end of the bull market.
As for earnings growth, companies must become less dependent on the plump profit margins engineered by cost-cutting and other maneuvers and more reliant on revenue growth. "I'm cautious," says John Toohey, who directs stock investments for USAA. "And my caution revolves around one theme: We need to see more revenue growth."
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Since the financial crisis, per-share earnings growth has been strong as companies have cut costs, refinanced high-cost debt, lowered tax bills and bought back shares. A recent spike in mergers and buyouts is aimed at buying revenue growth, Toohey adds. But he and others would prefer to see more growth coming from actually selling more goods and services. "We're a little surprised we haven't seen it yet," says Toohey.
Such growth will hinge on whether the economy can finally accelerate convincingly. Kiplinger's expects gross domestic product to expand by 2.4 percent this year, up from 1.9 percent growth in 2013, with the growth rate picking up to 3 percent or better in the second half. Many of those who are optimistic about the economy and the stock market are pinning their hopes on another crucial transition -- the one in which companies segue from stockpiling cash to spending it.
"We're five years out from the Great Recession," says Joseph Quinlan, chief market strategist at U.S. Trust, Bank of America Private Wealth Management. "Companies have been hoarding cash. The next five years will be about deploying it."
In recent years, companies have spent generously on dividends and share buybacks. But a resurgence in corporate spending on physical assets, such as factories, equipment and office space, has been the missing link to more robust economic growth. Such capital expenditures are part of a virtuous cycle as increasing production necessitates spending, in turn creating jobs and income growth, which then increases consumer demand, boosting corporate revenues and profits.
The time is ripe for a capital-spending recovery. With some $1.6 trillion on the books of S&P 500 firms as of year-end, cash stockpiles are enormous. Commercial and industrial lending is also picking up. And companies are nearing the point at which they can't squeeze any more production out of existing plants and equipment.
The average U.S. structure, be it a power plant, hospital or restaurant, is 22 years old. That's close to a 50-year high, reports Bank of America Merrill Lynch. The average age of business equipment, including computers and machinery, is more than seven years old, the highest since 1995.
Buybacks lose favor
Meanwhile, spending on share buybacks, a winning strategy until recently, is now penalizing companies and investors as rising stock prices make such programs expensive. The 20 percent of companies with the largest number of share buybacks in relation to their respective market values outpaced the S&P by nearly nine percentage points in 2013 but lagged the index slightly in the first quarter of 2014, says BMO Capital Markets. Shareholders are voicing their preference for spending on capital equipment over buybacks, dividends and acquisitions.
Bank of America Merrill Lynch sees capital spending growing at a rate of 4.7 percent this year and 5.7 percent next year, more than double the 2.6 percent growth rate in 2013. Beneficiaries of a spending boom would include tech, industrial and energy companies, as well as companies that discover and process raw materials. These economy-sensitive sectors together account for more than 40 percent of revenues generated by S&P 500 companies.
Tilting your portfolio toward economy-sensitive stocks in general is in order as economic growth picks up, and a number of money managers favor these so-called cyclical stocks. USAA's Toohey recommends Eaton (ETN -0.54%, news), a maker of industrial equipment. The 2012 acquisition of Cooper Industries is boosting revenues at the company's electrical products and services unit, its biggest division.
Jim Stack, of InvesTech Research, is a fan of software giant Oracle (ORCL -0.09%, news), which has attractive growth opportunities in cloud computing and is trading at just 13 times estimated year-ahead earnings.
Osterweis manager Berler likes Occidental Petroleum (OXY -0.21%, news), a resource-rich energy company that has decades' worth of drilling opportunities with its existing assets, as well as one of the strongest balance sheets in the industry. Investors interested in owning a broad array of industrial concerns can explore iShares U.S. Industrials (IYJ -0.21%, news), an exchange-traded funds.
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