How to survive what could be a volatile 2014

Friday, February 7, 2014, Vol. 38, No. 6

Last week, the government released GDP statistics for the fourth quarter of 2013 showing the economy expanded at a 3.2 percent clip, which was above.

For the full year, the economy grew a less-impressive 1.9 percent, but momentum was clearly built into the back half of the year. Expectations for 3 percent annual growth in 2014 remain intact.

Half of the companies within the S&P 500 have now reported, and it appears earnings grew 8 percent in the fourth quarter. 2014 earnings are expected to grow 10 percent.

So far this year, the S&P 500 has declined more than 4 percent. With the economy and earnings briskly rising, this seems nonsensical. However, understanding this dynamic will help you survive what could be a volatile 2014.

The Four Combinations

Of the 30 percent the market returned to investors last year, nearly 20 percent came from valuation expansion. Earnings growth and dividends contributed the rest.

There are four basic combinations for valuations and earnings:

  1. Valuations up, earnings up
  2. Valuations down, earnings down
  3. Valuations up, earnings down
  4. Valuations down, earnings up

Clearly, the most potent combinations are a synchronized rise or decline in earnings and valuations. We tend to see these combinations in new bears and old bulls. When earnings and valuations move in opposite directions, the market’s path can feel disconnected from the fundamentals.

For instance, in 2011 the economy grew 1.8 percent. Earnings grew 15 percent. How did stocks do? 0 percent. Why? Valuation fell 13 percent.

As you recall, 2011 contained the U.S. debt downgrade and a host of other frightening events. For this reason, even though the fundamental backdrop was positive, stock market returns were canceled by the decline in valuations.

This brings us to the matter of framing 2014. Expect the global economy and earnings to grow as advertised.

However, with the Federal Reserve changing directions, expect high valuations to change direction, as well. A 10 percent pullback in valuation would cancel out the projected 10 percent growth in earnings for the S&P 500.

The tension between these two forces will likely create a good deal of anxiety and confusion for investors. With such a meager return outlook, should you sell?

The risk of a “valuations down, earnings down” scenario seems minimal given the positive economic backdrop.

A burn-off in valuation excess could set the stage for a subsequent “valuations up, earnings up” rally down the road. After the “valuations down, earnings up” tie in 2011, the market rallied 13 percent in 2012 as both earnings and valuations rose.

One last point. The media must explain each market wiggle on a daily basis.

You now know that the market tension this year will be caused by upward pressures from earnings battling downward pressures from valuation. This simple explanation will not boost ratings.

Choppy markets need scapegoats. Struggles in Argentina, Turkey, Ukraine, etc., all present compelling narratives. Don’t get drawn in. Correlation does not imply causation.

The economy and earnings will grow and valuations will reload. That’s the story of 2014.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.