Stock Market Outlook for the First Half of 2014

Currently, the stock market is flashing an enormous yellow caution light. It isn’t saying “run for the exits” quite yet, but caution and prudence are well advised.

The Great Rally of 2013 has been nearly parabolic with almost no sell offs or meaningful pullbacks. As a long time veteran of the securities industry this alone makes me cautious; parabolic moves, up or down, tend to be fragile and are vulnerable to severe retracements. Solid longer term moves tend to be more of a “two steps forward, one step back” sort of thing.

Fundamentally the market has gotten way ahead of itself. Earnings growth has been anemic and we are seeing just this holiday season that things are not yet back to the halcyon days of 2002-4. Unemployment remains stubbornly high and wages are stagnant.

Technically, the picture is also showing signs of over extension. Momentum indicators, such as the widely used MACD (Moving Average Convergence Divergence), can be thought of as a measure of conviction in the market. The MACD has been weakening after making a top in early November showing a gradual lessening of conviction in a further move higher. Market breadth as measured by new highs versus new lows also peaked around that same time and has since slackened.

While neither of these popular indicators are screaming “Sell!” They are absolutely advising caution. Another caution light, in my view, is the relatively low level of option-implied volatility, as measured by the CBOE Volatility Index (VIX). The VIX is often referred to as “The Fear Index” because implied volatility tends to soar in falling markets and move lower in rising markets. It can also be seen as the “Complacency Index” as it is indication of how over or underinsured the market is against a violent move. At this writing the VIX is trading at 14.75.  That’s nearly 20% above its recent November low, another cautionary sign.  When jumping off the Fiscal Cliff seemed imminent a few short months ago the VIX was 22, so there could be more upside here if and when the market sells off.

So what has been driving this market? Simply put, liquidity. Quantitative Easing continues to pump billions of dollars into the system and that money has to go somewhere. With interest rates this low, debt instruments (think bonds) do not offer a return commensurate with the risk. And, contrary to the opinion of many, I do not believe that QE will stop or even slow down any time soon. Is that a continued bullish sign for stocks? Yes and no. The two major reasons I do not see QE ending are persistently high unemployment and no inflation to speak of. Inflation is often thought of as an economy’s worst enemy and in the case of runaway inflation that is true. But what really kills an economy is deflation. When a company cannot afford to price a product for more than it costs to make it and consumers take a “why buy now it will be cheaper tomorrow” attitude there is no room for growth. In my view, a little inflation now would be a healthy thing. The risk is that the Fed will “fight the last war” and raise interest rates and/or turn off the pump at the first hint of inflation.

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One may wonder if I am  advising a go straight to cash strategy. No, I am not. There are still good investment opportunities out there if one does careful stock selection, with this caveat: Look for yield, not growth.

What do I mean by yield? Good old fashioned dividends. I like dividends. I believe that companies should pay part of their profits to the owners (i.e., the shareholders) rewarding taking the capital risk of ownership, as opposed to stock buy backs, which only enrich management and reduce the liquidity of the stock (a topic for a future article).

As examples, here are three strong companies that pay a solid dividend with a good history of maintaining or raising their dividend over a number of years:

A perennial favorite is AT&T (T). With the stock at 34.65 it yields a very respectable 5.20%. It also has an unbroken dividend growth for the past 28 years. Admittedly, the price earnings ratio is a relatively high 25.36. Technically, its MACD is at zero, giving a neutral reading and its Relative Strength (RSI) is below 50, showing a slightly oversold condition. I don’t see a lot of downside risk to this stock and its solid dividend yield makes this a good and cautious investment.

Consolidated Edison (ED) has a solid dividend yield of 4.45% and 38 straight years of dividend growth. The P/E is a modest 15.74%. The MACD is slightly negative, showing an oversold condition. This is confirmed by a low RSI of around 25. A utility such as this will never be a boomer of a stock but is exactly the sort of defensive stock to own right now.

Intel (INTC) is slightly more speculative. It has the lowest dividend yield of the three at 3.83% but it also has a very low P/E of just 12.70 (the current P/E of the entire S&P 500 is 19.71). Technically, the MACD is neutral at zero while the RSI is also neutral at 50.

In an overbought market such as this one these three stocks are good choices. The Bull will not turn Bear overnight; the long term trend is still higher and we are still in a bull market. The S&P 500 is up 27.40% and the market is over extended. This is a spectacular one-year return by any measure and caution, combining with careful stock picking and a search for yield is the right way to approach 2014.

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