3 Reasons Stocks Can Go Higher in 2014

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

The market is kicking off the new year slightly lower, with the S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES: ^DJI  )  are down 0.59% and 0.57%, respectively, just before 10:15 a.m EST.

After a stunning market performance in 2013, the notion that stocks have become overpriced and must correct is gaining ground. Here are three reasons that suggest the stock market can still head higher this year:

Investor sentiment remains muted
Last May, with a journalist's taste for hyperbole, I christened this bull market "the most mistrusted stock market rally in history." While last year's market performance has gone some ways toward erasing individual investors' skepticism regarding stocks, we are hardly at a point of general euphoria that characterizes the end of a bull market.

The most recent reading of the AAII sentiment survey has 43% of investors declaring themselves bullish and 29% bearish; those numbers are not wildly different from the results one year ago when 39% of investors were bullish and 36% bearish. Furthermore, the current bullish reading is lower than the maximum figures achieved since 1987, the first year for which the data is available. Conversely, the bearish reading is higher than the minimum figures seen since 1987.

Headline valuations appear reasonable
On the basis of estimated operating earnings for 2014, the S&P 500 is valued at 15.2 times earnings per share -- not the kind of P/E that inspires fear, or even concern. In truth, there are good reasons to be at least somewhat skeptical regarding that figure, which is based on an estimate that assumes 13% earnings growth this year, suggesting that analysts' forecasts may be a bit aggressive. The Shiller P/E, for example, which uses a 10-year average of inflation-adjusted earnings, is at 25.8 -- significantly above its long-term average.

However, the Shiller P/E is not widely used; most analysts and financial media refer to a P/E calculated on forward earnings and that is, therefore, the number investors focus on. Bear in mind that my thrust in this article are the reasons for which investors could push stocks higher, not whether all those reasons are valid.

The "Great Rotation" is only beginning
The notion of a "Great Rotation," in which investors would switch their assets from bonds into stocks, was very popular at the beginning of 2013 (according to Google Trends, use of the term peaked in February); however, if such a rotation is occurring, it is only in its infancy -- at least with regard to U.S. stocks.

While it's true that 2013 marked the first year since the Great Recession that saw positive flows into U.S. stock mutual funds and outflows from bond funds, the $20.9 billion in funds the Investment Company Institute estimates saw their way into stock funds is a trifling amount relative to the $527 billion that were previously withdrawn since 2008. Conversely, the $77.2 billion that came out of bond funds pale in significance to the $996 billion that went in prior to that.

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