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Tech stocks and industrials will outperform in 2014

By Banu Simmons

The S&P 500 Index (SPX) closed the year with its best performance since 1997 as the global economic recovery gained momentum. As we move into 2014, the US economy has been showing the signs of sustainable growth despite the increased taxes and spending cuts, put into effect in 2013.

Furthermore, the US fiscal drag has been waning. The U.S. federal budget deficit in 2014 is expected to come down to around 3 percent of GDP, which is only one-third of what it was in 2009 when the US economy was at the height of the recession.

A budget deficit that is in line with the standards set by the Maastricht Treaty is an encouraging backdrop for the growth potential of the economy. The US Federal Reserve's scaling back of asset purchases in 2014 may shift the market's focus from uncertainty about the monetary policy and the provision of liquidity, to company earnings.

The US corporate sector looks strong from a balance sheet point of view. The share of company profits in nominal output has been steadily rising whilst the share of labor has been falling due to weak wage growth. The main problem with the US corporate sector in 2013 was that companies were uncertain about the economy and in particular, about the strength of consumer demand.

As a result, capital spending has been relatively subdued, gross fixed investment hovering around 2.5%. While companies preferred to spend for share buybacks and increased dividends in 2013, sustainable earnings growth can only be achieved through boosting capital spending.

We believe that with falling unemployment, and rising house prices, consumer confidence will further improve in 2014 and there will be some pick-up in wage growth. A more positive outlook of consumer demand is expected to convince the US corporate sector to increase investment spending.

As gross fixed investment spending recovers, we expect the Fed, under new Chairman Yellen, to be supportive of economic growth fundamentals in 2014. Given that inflation is not expected to exceed 2% in the current year, Fed can continue to pursue near-zero short-term interest rates in the first half of 2014.

We believe that the US unemployment rate could reach the Fed's threshold of 6.5% by 2014 Q3. We expect the Fed using "forward guidance" as the economy moves toward its trend growth path. Assuming that there are no major negative surprises, we expect the US economy to grow robustly in 2014, with an annual real GDP growth of at least 2.5%.

As far as the global outlook is concerned, we expect Europe to reach double digit growth rates in 2014. For the Eurozone, we do not expect the real GDP growth to be below 1.5% .

As far as the US equity market is concerned, the consensus market belief is with regard to expensiveness of the US stocks. As the trailing P/E of the S&P 500 in 2013 moved above its long-term average (16.6 versus 15.7) sustainability of further stock gains in 2014 were questioned. Here are the current valuation figures as of Jan. 9.

We believe that the US stock market may be somewhat overvalued but not yet in the bubble territory. One approach to evaluating the richness of the market is to compute the Tobin's q, the ratio of market value of corporations to the replacement cost of tangible assets.

Normally, if the q ratio is greater than 1, it means that the firm is earning a rate of return higher than that justified by the costs of its assets. The data for non-farm, nonfinancial companies can be constructed from the Flow of Funds Accounts of the United States issued by the Board of Governors of the Federal Reserve System.

As the market value of corporations only considers the public companies, the long-term average of the ratio is around 0.7, rather than 1. Using this metric, the q ratio for 2013 q3 is 0.99, which indicates overvaluation given its historical mean.

Normally, the market interprets a high value of q as a signal for a forthcoming crash. However, the q value is nowhere near its level in the year 1999 (1.83) and for many internet-based companies such as Facebook (FB), or Twitter (TWTR), the value of tangible assets at replacement cost is not a meaningful measure of their capital, as the replacement value of intellectual capital is not measured in the denominator of the q ratio.

Thus, instead of an approaching stock market crash, we interpret the current high q ratio as an incentive for higher capital spending, which may self-correct as increasing capital stock should reduce the marginal productivity of capital, thereby reducing the q.

In 2014, we expect technology stocks to continue performing well, and we also expect some industrial stocks to outperform. Despite the market expectation of a stable oil price, we see a certain upside potential with selected US energy stocks which may benefit from increasing oil production in the US over the next few years.

We also believe that the global recovery should be reflected in the recovery of demand for commodities. Clearly, the pace of supply from Middle East will be crucial for the future of the oil price. The main risk to our forecast is a possible slowdown in China which may have a dampening effect on commodities demand.

In the month of December last year, we made no change to the composition of our portfolio.

DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. Past performance is no guarantee of future results.

Banu Simmons

Banu Simmons

I have a decade of financial sector experience as an econometrician/quantitative analyst. Furthermore, I conduct academic research on equity analysis

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