Stock market begins new year in the red

The older I get, the more I see a straight path where I want to go. If you’re going to hunt elephants, don’t get off the trail for a rabbit. – T. Boone Pickens, American business magnate and financier, corporate raider and takeover specialist during the 1980s

After finishing the year at an all-time high and recording its biggest annual percentage gain since 1997, the S&P 500 posted a loss in the first trading day of the New Year, something that hasn’t happened since 2008. Apparently investors did too much celebrating on New Year’s Eve and suffered a hangover that resulted in a modest loss to start 2014. It might have been just a case of good, old-fashioned profit taking that saw stocks lose almost 1% on Thursday as the economic data was generally positive. Jobless claims fell to the lowest level in a month and the manufacturing data was virtually unchanged from the previous month. But the lackluster start to the year should not be cause for concern as trading volume was low during the holiday-shortened week as many market participants were away from their desks. In fact, in a week with very little market-moving data available, it was the Federal Reserve that grabbed the headlines on Friday as Fed Chairman Ben Bernanke and two other Fed presidents offered their assessment of Fed policy and prospects for the economy. After the presidents discussed the challenges ahead in reducing the monthly bond purchases and the inevitability of higher interest rates, Gentle Ben assuaged investor concerns by saying that the U.S. economy will continue to improve and that the Federal Reserve will remain as accommodative as necessary by keeping interest rates low. Such assurances by the outgoing Fed chairman would seem to portend another good year for stocks provided that the improved economic growth translates into higher corporate earnings.

Last Week

The housing market continues to show improvement as the S&P/Case Shiller home price index rose 13.6% for the year ended in October, the largest annual gain since 2006. The November report on construction spending also registered continued strength in both residential and commercial investment and the ISM purchasing managers’ index showed that the manufacturing sector is expanding at a rapid rate. All in all, these home price, construction and manufacturing data confirm an economy that is growing at better than a 2% rate in the fourth quarter and bodes well for the outlook in 2014.

For the week, the Dow Jones Industrial Average declined 0.1% to close at 16,469 while the S&P 500 Index lost 0.5% to end the week at 1,831. The Nasdaq Composite Index dropped 0.6% to close at 4,131.

This Week

With all hands back on deck and trading volume expected to return to normal this week, the calendar also promises to be full in terms of economic data. The Institute for Supply Management (ISM) announces its services sector report and that is expected to show that the sector is healthy and still expanding. The Federal Reserve also releases the minutes of its December meeting and may provide details of its tapering plans over the first six months of the year. Jobless claims are expected to fall modestly and the unemployment rate for December should remain at 7.0% with about 200,000 new jobs created, another sign of a gradually improving labor market.

The governing council of the European Central Bank meets this week and will likely make no changes with regard to its accommodative monetary policy. On the earnings front, all eyes will be focused on Alcoa as it kicks off the start of the fourth quarter corporate earnings season.  Other notable companies that will release their profit reports for the quarter include Monsanto, Bed Bath & Beyond, Family Dollar Stores and Supervalu.

Portfolio Strategy

Although the stock market has begun the year in negative territory, there are a number of positive factors that could lead to further gains in stocks this year. From an economic standpoint, the housing market and the manufacturing sector are gaining strength and consumer spending has picked up in part due to the wealth effect provided by a strong stock market. Even with the Federal Reserve tapering its monthly bond purchases, monetary policy will still remain very accommodative as Fed Chairman Bernanke said last week. Corporate balance sheets are also sitting on almost $2 trillion in cash that could be used for stock buybacks, dividend increases or acquisitions. Corporations also seem to be more confident about the prospects of a stronger economy, which could lead to increased capital spending and business investment. While corporate earnings are expected to only grow in the 5% to 7% range, this growth should be good enough considering that interest rates and inflation remain low. There also is about $10 trillion in cash that is held in money market funds that yields virtually nothing. This money, along with money held in fixed income funds, could continue to move into stocks and equity funds during the year. From a valuation standpoint, stocks are neither expensive nor cheap but fairly valued based on projected earnings forecast for this year. Continued low interest rates and inflation could easily provide the backdrop that leads to further multiple expansion. Lastly, if history is a guide, in years following gains of more than 26% in the stock market, stocks are generally positive. While it is obviously very early in the year, there are a number of reasons to be optimistic about the direction of stock prices, though the road may be a bit bumpy at times.