Warning from Wall St for US investors

Last updated 05:00 03/01/2014

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2013 was a great year for the average investor, but few market strategists believe that 2014 will be as good. The simple strategy of buying US stocks, selling bonds and staying out of international markets isn't going to work as well as it has, they say.

Some of Wall Street's biggest money managers have come up with a few resolutions to help investors:

CURB YOUR EXPECTATIONS

Few investors expected 2013 to be as big as it was. The S&P 500 index is up 28 per cent for the year, its best year since 1997. Including dividends, it's up 30 per cent.

On average, market strategists expect 2014 to be somewhat tame. Most are looking for the S&P 500 to rise to 1,850 to 1,900 points, a gain of just 2 to 4 per cent.

KEEP YOUR EYE ON VALUATION

Investors bid up stock prices to all-time highs this year, despite a mediocre economy and corporate profits that were less than spectacular.

At the beginning of 2013, the price-to-earnings ratio on the S&P 500 was 13.5, meaning investors were paying roughly $13.50 for every $1 of earnings in the S&P 500. Now the S&P 500's P-E ratio is around 16.7.

While a P/E ratio of 16.7 won't set off any alarm bells - the historical average is 14.5 - it is noticeably higher than it was a year ago.

Investors have high expectations for corporate profits, based on the prices they are paying.

"It's hard to believe that this market can go much higher from here without some corporate earnings growth," said Bob Doll, chief equity strategist at Nuveen Asset Management.

Profit margins are already at record highs, and corporations spent most of 2013 increasing their earnings by cutting costs or using financial engineering tools like buying back their own stock.

Earnings at companies in the S&P 500 grew at an 11 per cent rate in 2013. The consensus among market strategists is that profit growth will slow to around 8 per cent in 2014.

However, if the US economy continues to improve, and corporate profit margins expand, it could justify the prices investors have been paying for stocks.

DON'T GET CAUGHT UP IN THE EUPHORIA

Be wary if your neighbour decides to jump head-first into the market.

A large number of investors have remained on the sidelines for this five-year bull market. Since the market bottomed in March 2009, investors pulled US$430 billion (NZ$523b) out of stock funds, according to data from Lipper, while putting nearly US$1 trillion into bond funds.

Professional market watchers are concerned that many individual investors, trying to play a game of catch-up, might rush into the market. The surge of money could cause stocks to jump if investors ignore warnings that the market is getting overvalued.

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Wall Street calls this phenomenon a "melt-up." As you can guess, a "melt-up" could lead to a "melt-down," as happened in the late 1990s with the dot-com bubble.

"I fear people, who sat out 2013, will jump in too fast next year and get burned," said Richard Madigan, chief investment officer for JPMorgan Private Bank.

Which leads us to:

DON'T PANIC, EITHER

Stocks cannot go higher all the time. Bearish investors have been saying for months that stocks are due for a pullback in the near future.

The S&P 500 is up 66 per cent since the stock market's last major downturn in October 2011. It has been resilient through several scares this year, including the conflict in Syria, the budget crisis and near-breach of the nation's borrowing limit in October.

In their 2014 outlook, Goldman Sachs analysts said that while the market has been strong, they see a 67 per cent chance that stocks will decline 10 per cent or more in 2014, which is known as a stock market "correction."

Goldman analysts still expect stocks to end the year modestly higher.

CUT YOUR EXPOSURE TO BONDS

Fixed-income investors had a tough year in 2013. The Barclays Aggregate bond index, a broad composite of thousands of bonds, fell 2 per cent. Investors in long-term bonds were hit even harder, losing 15 per cent of their money since the beginning of the year, according to comparable bond indexes.

2014 is not looking good for bond investors, either.

The Federal Reserve has started to pull back on its bond-buying economic stimulus programme. That means one of the biggest buyers of bonds for the last year will slowly exit the market this year.

The exit could send bond prices falling.

"Bonds are hardly a place to be in 2014," Nuveen's Doll said.

That doesn't mean investors should avoid bonds altogether, strategists say.

Instead, investors should reorganise their portfolio to focus more on bonds that mature in relatively short periods of time. The prices of those bonds tend to fluctuate less than those of bonds that take longer to mature, and are less likely to lose value when interest rates rise, as many expect will happen .

Madigan said that under normal circumstances he would advise investors to hold bonds that mature in an average of about five years. This measure is referred to as a bond's "duration".

For 2014, Madigan is advising investors to restructure their portfolio to have an average duration of two to two-and-a-half years.

"Long duration bonds are much more a riskier asset than a safe asset next year," Madigan said.

YOUR STOCK MARKET ALTERNATIVE IN 2014 IS . . . STOCKS

Other than stocks, the average investor typically has access to three other types of investments: cash, bonds and commodities such as gold.

None are expected to perform better than the stock market this year.

If bonds had a tough 2013, gold investors got punched in the stomach. Gold is down 28 per cent this year, and is on its way to its first annual loss since 2000.

Gold is expected to have another tough year, with inflation under control and the Fed expected to gradually exit the bond market. Analysts at Barclays Capital expect gold to end 2014 at $1,270 an ounce, about 6 per cent higher than where it is today.

Cash is expected to provide a near-zero return next year. Savings and money market-accounts are returning less than 0.1 per cent on average.

STUDY ABROAD

Several market strategists believe international stocks will be the place to be. Asian and European stocks did not perform as well as US stocks in 2013, with the exception of Japan, where the Nikkei 225 index soared 53 per cent.

Europe is particularly attractive, they say. The European Union came out of a two-year recession in 2013, and the debt crisis that plagued most of the region has abated. Some strategists say that Europe is a couple of years behind the US in its economic recovery, and stocks could be relatively cheap.

"The big debate among my team is whether international markets will play catch-up next year," said Madigan of JPMorgan Private Bank. AP

- AP

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