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On Wall Street, 2014 is ending just as 2013 did. A January warning?

Yahoo Finance

As a fresh year approaches, a strong fourth-quarter rally carries stocks to a new high as December ends, economists are projecting the economy will lift off and investors grow enthusiastic about further upside in the coming year – even as they anticipate higher interest rates.

That’s how 2013 finished up – and also the way the current year is closing.

What makes this more than a simple seasonal curiosity is the fact that the upbeat close to 2013 was followed by a rude and jarring New Year’s market decline that sank the Standard & Poor’s 500 index by nearly 6% in a month.

As I discuss with Yahoo Finance’s Rick Newman in the accompanying video, the synchronicities in market conditions this year compared with a year ago are striking:

-From its low following an early October pullback, the S&P 500 this year is up 11.9%. From the October 2013 low, the index climbed 11.7% through year-end. In both cases, there was a powerful surge forming a “V” bottom in October, followed by a slight pullback in early December and a somnolent upward drift in each year’s final weeks.

The rebound in equities brought the attendant collapse in demand for downside protection and traders’ expectations of volatility. The CBOE S&P 500 Volatility Index fell from 21 to below 14 in the late-2013 rally, and in recent months has dropped from 25 to around 15.

-Retail investor sentiment has brightened to the same sunny levels as a year ago. In the latest weekly survey by the American Association of Individual Investors, 50% were bullish on stocks versus only 19% bearish. A year ago, that split was 49% to 21%.

Reflecting the recent upbeat mood, investors poured $34.5 billion into equity mutual and exchange-traded funds, the most in Thomson Reuters Lipper’s database dating to 1992.

-Wall Street pros are also striking a familiar tone of near-universal (if not overly aggressive) optimism toward the American economy and stocks, while predicting (yet again) that Treasury bonds will lose favor and interest rates will climb.

The average forecast for stocks in 2015 – a year when the bull market will most likely turn six years old – is for around a 10% gain. A year ago, investment firm strategists were a bit more cautious, looking for around 6%, or about half the upside that 2014 is poised to deliver.

Déjà vu, or never mind?

Does the similar arrangement of market conditions and investor expectations this year and last imply that we’re set up for another early-year flop?

Nothing says this must happen. And now that the echoes of last year are being discussed, it may diminish the chances for an exact replay.

But when markets drift higher and complacency grows, the odds rise for some adverse rush of news to unsettle the comfortable consensus with a short-term setback.

This is what happened last January, when a blissed-out market was hit by a storm-struck deep freeze that snarled business activity, a mini-panic in emerging markets and a spate of downbeat profit reports from big U.S. companies.

The overbought market sold off hard before bottoming in the first days of February, down 5.8%. While the S&P 500 recovered to put in another nice return for the full year, the index was near the flat line for several months and smaller stocks struggled until this week to get even for the year. (Of course, stocks were up nearly 30% in 2013 versus around 13% this year, so perhaps there is less “froth” to be skimmed away as 2015 begins.)

Among the factors that argue against another jarring “growth scare” is the fact that the U.S. economy truly does have more momentum than it did a year ago.

There are 2.9 million more Americans working today than in December 2013, energy prices have tumbled, consumer confidence rose to a seven-year high, wage growth seems finally to be percolating and U.S. companies have maintained lush profit margins.

Perhaps we’re entitled, at last, to a “belief phase” of this bull market — a stretch of time when good news for the economy is good for stocks and obvious improvement in the economy enriches confident investors.

In this context, another quick shakeout in which stocks pull back hard without a lasting disturbance to the economic fundamentals would probably be the healthiest and most welcome outcome for long-term investors early in 2015.

In need of a ‘new story’

For this to happen, a new prevailing “story” animating the market probably needs to take hold. Instead of stocks simply being dragged higher by their value relative to low-yield corporate bonds, aggressive share buybacks by companies and abiding hope for more central-bank largesse, organic consumer-driven top-line growth will need to kick in.

Since the fall, consumer-geared stocks such as restaurant chains and retailers have indeed performed well, hinting that such a shift is at least tentatively underway.

In a dream scenario making the rounds, we’re in for a melt-up phase in which markets get more volatile but a humming economy, raging corporate deal-making and belated public excitement over stocks drives the market steeply higher and (eventually) invites a bubbly endgame.

Yet it’s worth recognizing just how far equity values have come in rising more than 200% since March 2009 on the strength of a slowly improving economy and copious cheap liquidity, leaving the S&P 500 trading at a heady price-earnings multiple of 20 based on the past year’s reported results. It shouldn’t come as a shock if the economy outperforms stocks for a while after several years of the reverse being true.

As Michael Hartnett, BofA Merrill Lynch chief investment strategist writes: “We believe the plunge in oil price may, together with the recovery in the U.S. labor market, be the catalyst to reverse the massive post-Lehman outperformance of Wall Street versus Main Street. Overweighting assets related to the recovery on Main Street and underweighting assets tied to reflation of Wall Street in recent years has the potential to be The Trade of 2015. We would also hedge against the risk of a 1999 repeat, the ‘iBubble’ scenario.”

Rate risk?

If this is, in fact, the year when long-term Treasury rates finally start to climb, the main leaders of this year’s market gains – bond-like utility, consumer staples and healthcare stocks – could have a hard time holding up.

And, of course, oil-and-gas stocks have been trashed and cuts in energy spending will hamper a sector that has received a disproportionate share of investment capital in recent years.

Finally, if the rest of the world economies don’t rebound, can big U.S. multinational stocks continue to lure fresh investor dollars? And if foreign economies do improve, won’t their laggard, cheaper stock markets likely outperform American stocks, which, this year, were viewed as the “place to be”?

Such preliminary questions can seem like trying to pick a winner in football against the point spread. Which is why, as they say, they play the games on the field and not on paper.

tracy collins

I am a freelance writer blogger social media marketer and content marketer with twelve years of experience in writing and blogging.

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