Returning to a Normal Market

Stocks have slipped from their 2013 highs, with the S&P 500 down more than 4% so far in 2014. The interesting thing is that stocks have been falling at a time when the U.S. economy is continuing to show signs of improvement. It is obvious that the Federal Reserve's tapering is having a negative impact on equities. But investors should not panic at this stage, as we are simply returning to a normal market.

A weak start
2014 has kicked off on a weak note for equity markets. The sharp decline has come as a surprise, given that investors entered 2014 on a much more confident note than last year.

Remember that at the beginning of 2013, there were initially fears of a "fiscal cliff," which was only averted with a last-minute deal later in the year. We saw a government shutdown in the U.S. for the first time in more than a decade. All the while, the U.S. economy showed signs of improvement but was nowhere near a full recovery. Still, equities rallied, suggesting that the rally in 2013 was fueled by QE3.

At the end of last year, the Federal Reserve announced that it would start tapering its bond purchases in January. The Fed, in its most recent FOMC, said that it would further ease its bond purchases by $10 billion in February despite the turmoil in emerging markets. The fact that the Fed is now determined to end its quantitative easing is obviously is having a negative impact on equities. The impact of Fed tapering has been accentuated by the turmoil in emerging markets.

Not yet a bear market
Although stocks are down sharply this year, we are still long way from entering bear-market territory. Equities would enter a bear market only if they were to fall 20% or more in a short period of time. In fact, the recent drop cannot even be called a correction, which requires a 10% drop.

If anything, the recent drop in equities should be seen as a good sign. If the economy continues to improve and the Fed ends its bond purchases by the end of this year, it would be a positive for equities. This would mean a return to a normal market that moves on the basis of fundamentals.

Of course, returning to a normal market would also require a change in investment strategy. The Fed-fueled rally of 2013 meant that passive investing was the perfect strategy. But with the markets normalizing, 2014 looks ideal for stock picking.

So what to buy in a normal market?
With the economy improving -- U.S. GDP grew 3.2% in the fourth quarter -- cyclicals are the best bet. However, investors also have to consider the outlook for individual companies. For example, while my outlook for auto sales in the U.S. is bullish, in the near term I would remain on the sidelines with Ford Motor (F 0.08%), which recently reported fourth-quarter and full-year 2013 results.

Although Ford's performance in 2013 was strong, the company has already warned about profits in 2014 as it launches new vehicles, which will increase its costs. Ford is planning to double its new-model introductions globally, which will impact its bottom line. In North America, the company expects its pre-tax profit to be lower in 2014 than in 2013. The company had a pre-tax profit of $8.78 billion in North America last year. In Asia-Pacific, which is another key driver for Ford, pre-tax profit is expected to be about the same as in 2013 as the company makes investment to support growth in 2014 and beyond. Of course, these investments will benefit Ford in the future, especially if auto sales in the U.S. remain strong. Therefore my outlook for the automaker in the long term is bullish.

Industrials such as General Electric (GE -2.11%) and United Technologies (RTX -0.35%) should also benefit if the economy continues to improve. In fact, the improving prospects for the economy are reflected in the $244 billion backlog in GE's industrial segment as of the end of the fourth quarter -- the company's highest backlog ever.

The company's orders rose 8% in the fourth quarter of 2013, with "growth market" orders surging 13% and U.S. orders expanding 8%. The company even saw 3% growth in orders in Europe. As a result, the company's industrial earnings growth was up 12% in the fourth quarter, and the company expects this to continue in 2014.

United Technologies last month said that it expects to deliver 2014 earnings per share of $6.55 to $6.85 on sales of about $64 billion. The company's earnings per share in 2013 stood at $6.21. In a conference call following the release of quarterly results, CFO Greg Hayes noted that the solid organic growth in backlog exiting the year gives the company confidence in its sales assumption of 3% to 4% organic growth in 2014. Hayes expects continued recovery in North American markets, slight growth in Europe, and solid growth in China.

Last year's rally has meant that valuations are quite high at the moment. However, there are still some opportunities, especially in cyclicals and industrials. Overall, 2014 looks like a good year for stock picking as the Fed eases its bond purchases.