Why the Markets Should Expect a Sour 2014

After surging 30% through 2013 to finish at 1848.36 points, the S&P 500 (SNPINDEX: ^GSPC  ) has begun 2014 amid a swirl of debate. Will the S&P 500 and fellow major index the Dow Jones Industrial Average (DJINDICES: ^DJI  ) be able to build on an impressive 2013? Here are three trends to watch in 2014 -- and why I think the answer will be "no." 

Are the markets overpriced?
As early as last summer, the Shiller P/E ratio had reached 24 -- more than 30% above the market's historical average. With the ratio around 26 today, we're quickly approaching the third-highest level in history. The inventor of the ratio, Yale professor Robert Shiller, famously predicted the dot-com and housing bubbles using this smoothed-out version of the P/E ratio, so its track record makes the recent spike troubling, to say the least.

Source: Multpl.com.

To hone in on more recent data, here's a graph highlighting the percentage change between the index price and earnings per share for the S&P 500 from 2007 to 2013.

Source: Standard & Poor's; author's calculations.

As you can see, the gap between earnings and prices continues to widen. The index has returned 50% over the past two years, while EPS have gained just 11%. Even if the S&P does meet estimates of a 22% earnings increase for 2014 (nearly three times the average from the past 25 years) it would only meet historical P/E valuations if the index traded flat. 

Now for the stories
Of course, investors don't always rationally analyze the underlying valuation of the overall equity markets before making investments (and in all reality, it's not as if they really should). Larger macroeconomic factors can strongly affect confidence and determine whether companies have a successful 2014.

The most important number, arguably, will be the unemployment rate. It's one of the key factors behind Federal Reserve decisions regarding quantitative easing. As you can see here, it's been falling pretty steadily of late:

Source: U.S. Bureau of Labor Statistics. 

In the most recently reported month (November 2013), unemployment finally dropped back down to 7%. Unfortunately, official unemployment doesn't tell the whole story. Because of the long-term recession, many workers simply dropped out of the workforce -- meaning they're not counted in unemployment statistics. This drops the unemployment rate to "artificially" low numbers.

Without a doubt, the recent unemployment data is encouraging. With the "real" unemployment rate reportedly higher than 14%, though, the U.S. recovery, while a reason for long-term optimism, still has some way to go. Friday's news that the unemployment rate fell on account of people leaving the workforce confirms this notion as well. 

Source: Forbes.

There are a few ways to follow this trend. From a long-term standpoint, the numbers still describe a market preparing to grow, but the short-term outlook looks a little bleaker. Deeper unemployment issues suggest that the big revenue years could be a bit further into the future. This is evidenced by, among other things, the growing (but still low) levels of consumption spending (shown in the graph below). Given that the true signs of recovery could encourage many workers to return to work, we could start to see the unemployment rate "stick" close to current levels.

 

The Fed, the Fed, and -- did I mention the Fed?
As pointed out by Fool Morgan Housel, Federal Reserve researchers noticed in 2012 that "More than 80% of the equity premium on U.S. stocks has been earned over the twenty-four hours preceding scheduled Federal Open Market Committee announcements." In other words, investors clearly respond to speculation regarding the Fed. This isn't to say that the Fed actually causes those changes, but it certainly might be able to trigger them.

The Fed, of course, cut back on quantitative easing at its last FOMC meeting and is widely expected to do so again later in January. Given these expectations, it's tough to tell how investors will respond. On one hand, ending the program would likely hurt markets in the short term; on the other hand, investors are already expecting the Fed to begin cutting back, so "negative" news from the Fed might already be priced in. A reversion to the old strategy could mean a short-term jump. Either way, if the Fed does start to pull back, that's good news to long-term investors. After all, at least some of the country's premier economists believe the recovery has truly commenced.

Invest Foolishly
The Motley Fool believes in long-term investing decisions, so it's important to avoid changes based on short-term outlooks. That being said, investors do need to stay informed and alert about what's happening as the year progresses -- particularly at the beginning of the year and around annual portfolio rebalances. There are plenty of reasons to expect a pretty flat 2014.

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