Where to Invest in 2014

Where to Invest in 2014

  • Will the Obamacare fiasco wreck the healthcare sector – and the economy?
  • Inside: Market tops, market bottoms, and continued bull runs that are all likely to play out this year.

The year 2013 was one of the great divergences in global asset markets. Some asset classes, such as U.S. stocks, soared. Others, such as bonds and precious metals, went in the opposite direction. These divergent patterns will create new risks as well as new opportunities for investors in 2014.

The Federal Reserve has continued its program of Quantitative Easing (QE), now projecting a slightly lower, $75 billion in monthly bond purchases. Instead of lifting all assets, as was the case in previous years, QE’s liquidity spilled over primarily into the U.S. stock market.

Soaring stock prices in 2013 (the S&P 500 was up 29% for the year into mid December) diverged from a sluggish economy. A record 47.6 million people are now on food stamps. Sure, those at the top are doing well, and corporate profits remain healthy. But we’re not seeing a lot of capital investment to generate future business profitability.

As veteran Wall Street commentator Art Cashin observed, big corporations are “using the very low rates that the Fed is providing, in some cases to buy back their own stock, which then allows the earnings to look even better because it’s a smaller number of shares. And then finally, there have been very little capital expenditures. They’re not investing in the future, and that helps translate things to the bottom line, so earnings have looked good, making Wall Street look good. But they’re doing it with less.”

Corporations continue to engage in cost-cutting measures in order to boost their bottom lines – such as cutting back hours for employees or eliminating jobs entirely. Official unemployment statistics aside, the actual rate of labor force participation fell last year to its lowest level since Jimmy Carter was president.

The government’s numbers are lying – in more ways than most investors (and voters) know. According to the New York Post, an Obama Administration bureaucrat rigged the unemployment data ahead of the 2012 election to get the official unemployment rate below 8% and ensure that voters heard “good news” about the economy before they went to the polls.

2000, 2007, 2014:
Is Another Stock Bubble about to Burst?

Against the backdrop of bogus data and an uninspiring real economy, the near-euphoric action in the stock market is perplexing. As near as I can tell, the best explanation for it is the Fed. Investors think the Fed has their back, so they’ve grown increasingly comfortable with taking on risk. But I wouldn’t credit Ben Bernanke and company with boosting equities. I’d blame them. Because what they’ve done is create yet another asset bubble.

Nobel prize winning economist Robert Shiller called the 2000 stock market bubble and subsequent real estate bubble. He’s raising similar concerns about the stock market now. Shiller stated in a recent interview with Germany’s Der Spiegel, “I find the boom in the U.S. stock market most concerning.”

The Shiller 10-year Cyclically Adjusted P/E ratio (CAPE) for the U.S. stock market is a useful gauge of long-term valuation trends. From 1881 through the mid 1990s, the CAPE indicator got above 25 only once – during the roaring 1929 boom that ended in a crash. Today, stocks trade at 25.4 times their 10-year earnings average.

Stocks in late 2008 to early 2009 reached what could be considered fair value,
with a P/E ratio in the mid teens. But they never got to the deeply undervalued levels from which major secular bull markets usually begin. The 1929 crash and
the deflation that followed quickly led to P/E ratios falling to near 5. The 1970s inflationary bear market bottomed with P/E ratios also falling back into the single digits into 1982. That base of low valuation gave rise to the greatest bull market and mania in history into the 2000 high.

Bubble booms used to be rare events, occurring maybe once in a generation. But lately we’ve seen one Fed-fueled asset bubble cycle lead straight into another – stocks, housing, commodities, bonds, and stocks yet again. These rotating boom
and bust cycles marked by volatility extremes appear to be the “new normal.”

But they pose great risk to people who are either in the wrong asset classes at the wrong times or insufficiently diversified to be able to weather the gyrations. U.S. stocks could push higher still in the first half of 2014, but downside risk in the S&P 500 is substantial at these levels.

Doug Short of Advisor Perspectives notes, “Based on the latest 10-year earnings average, to reach a P/E10 in the high single digits would require an S&P 500 price decline below 550. …the new nominal all-time highs repeatedly set [in 2013] are conspicuous tick marks for the optimists. But the history of market valuations suggests a cautious perspective.”

Another tidbit to put the current bull market in perspective: According to DeepCaster LLC, “Over the past 40 years there have only been two other times when the DJIA [Dow Jones Industrial Average] has risen as fast and as far as it has off its 2009 low. The first was in the run-up to the 1987 crash. The second was in the late 1990s, during the dot-com frenzy.”

Clearly, value-oriented investors need to be looking outside the major U.S. stock indexes to find promising investing opportunities in 2014.

No Signs of Stock Market Bubbles in Emerging World

Unlike in 2007, when markets were globally overinflated led by emerging markets such as China, the irrational exuberance heading into 2014 seems confined mainly to the United States. I’ve long believed that emerging markets – with their younger, faster-growing demographic profiles and lower debt levels – will outperform the U.S. and Europe in a mega-trend that could last decades.

In spite of underperformance last year, I continue to believe that long-term investors can benefit from a significant weighting to the stock markets of the developing world. The upshot is that valuations are attractive, especially compared to U.S. equities.

Stock analyst Chris Mayer notes that among the big emerging economies, Russia is the cheapest. On the downside, Russia has a poor demographic profile, below-replacement fertility rates, and population decline projected for years to come. On the upside, Russia is rich in natural resources.

The Market Vectors Russia ETF (RSX) has been drifting sideways over the past couple of years and may be ready to start trending again. Similar price action can be seen in the more broadly diversified vehicle of Vanguard Emerging Markets (VWO).

It is likely that when the U.S. stock market starts correcting, so will the emerging markets. But it’s unlikely that another crash similar to 2008 will play out from these levels. So any pullbacks should be viewed as long-term buying opportunities.

Government-Fueled Gains
Could Give Way to Biotech Bust

What about sectors? The May 2012 Independent Living featured a story (“Decoding Your DNA”) on the exciting but controversial advances in the science of genomics.
We highlighted a specialty exchange-traded product, PowerShares Dynamic Biotech & Genome (PBE), as a way for investors to cash in. Since May 1, 2012, PBE has advanced more than 67%.

Given the massive run-up in biotech against the backdrop of a stock market that has entered overvalued territory, I’d contend that now isn’t as favorable a time to be accumulating biotechnology or healthcare-related shares as it was in 2012. Even the stodgy, dividend paying pharmaceutical stocks have had quite a run.

We had anticipated that Obamacare would be a boon to the whole healthcare sector (not to the healthcare consumer) by driving more spending on insurance, devices, drugs, etc. But Obamacare’s disastrous rollout and inability to enroll young people at rates the program’s own architects said were necessary for the program to work could have negative repercussions for the sector and the economy.

Millions of people now face dramatically higher insurance costs that they can’t or don’t want to pay. In addition, an alarming number of doctors are vowing to leave the profession over the new fee structures and other aspects of an unworkable system that is being imposed on them from Washington.

We don’t know how this will all play out, but the new government-imposed healthcare regime appears to be a catastrophe in the making for 2014. The government’s efforts to stamp
out medical self-reliance in this country know no bounds.

Government vs. Genomics Revolution

Also in the May 2012 issue, we highlighted the (then) availability of direct-to-consumer DNA analysis kits through a company called 23andMe. It had been offering such services since 2006. It had been, that is, until November 2013, when the Food and Drug Administration sent a warning letter to 23andMe ordering it to cease marketing its genotyping test.

Shortly thereafter, 23andMe posted this terse message on its web site: “We have suspended our health-related genetic tests to comply with the U.S. Food and Drug Administration’s directive to discontinue new consumer access…”

The FDA apparently thinks that individuals must be protected from health risk-factor information derived from an analysis they requested of their own genes. There may also be some ideological bias at work here. DNA reveals inconvenient truths for leftist social planners.

We are hard-wired to a large extent with specific natures, ranges of abilities, and proclivities. Soviet-era Marxists insisted that environment and social conditioning were everything, inheritance irrelevant. They dismissed the science of heritability as “bourgeois.” Today’s cultural Marxists dismiss potential genetic explanations for individual and group differences as “discriminatory,” “racist,” “sexist,” etc.

We as a nation seem to have difficulty facing the hard truths about anything, including the demographic, economic, debt, and monetary factors that point toward national decline.)

Inflation and Energy Outlook

Last month we presented a graph of the Continuous Commodity Index and noted that it was on the verge of breaking out of a long consolidation pattern in one direction or the other. Since then, commodity prices have showed signs of gathering strength, though they haven’t yet broken out convincingly.

Despite price weakness in crude oil and natural gas over the past couple of years, energy bills are actually on the rise. The average price of electricity rose for 11 consecutive months through October 2013, to a record 13.2 cents per kilowatt hour, according to the Bureau of Labor Statistics. Over the past decade, Americans have been hit with a staggering 42% increase in their electricity costs.

Energy from all sources – oil, coal, natural gas, nuclear, and clean alternatives – will require investment in the years ahead to meet rising global demand and avert intolerable price increases. There are many avenues for investors to profit in this area, and a diversified portfolio that includes all the major energy subsectors makes sense.

The natural resource sector has outperformed most other sectors for most of the 2000s, though the past couple of years have brought disappointment. The relatively low position of commodity prices gives incoming Fed chair Janet Yellen a green light to continue stimulating. Yellen is expected to be even more dovish on inflation than Ben Bernanke, who will leave his position with Wall Street lauding him for “saving” the financial system and helping to push the Dow to new record highs.

The “gains” from expansionary monetary policies are artificial. The unintended consequences, the “pains,” are still to come. I’ll quote a passage from The Death
of Money: the Coming Collapse of the International Monetary System
, the new book by James Rickards: “Inflation often begins imperceptibly, and gains a foothold before it is recognized. This lag in comprehension, important to central banks, is called money illusion, a phrase that refers to a perception that real wealth is being created, so that Keynesian ‘animal spirits’ are aroused. Only later is it discovered that bankers and astute investors captured the wealth, and everyday citizens are left with devalued savings.”

When the realities of inflation, underlying economic weakness, and unjustified stock market valuations set in, that’s when hard assets – especially precious metals – will shine.

What Obama’s War on Coal Means

One of the reasons why electricity costs continue to rise is the Obama Administration’s vendetta against coal. Aggressive environmental regulations are projected to force the closure of 207 coal plants in this country.

Utility companies are switching to natural gas, which is now plentifully supplied and relatively cheap, thanks to advances in fracking technology. But environmentalists don’t like fracking, either. And even if fracking is allowed to expand, it may not be enough to avert price increases.

A lot of people are now talking about energy independence for the U.S. and enough gas reserves to last for decades to come. What they overlook is that production at shale gas wells can drop 60% or more in the first year of operation. Extraction costs steadily increase after the top-producing wells are drawn. If natural gas prices start rising, “dirty” coal looks more attractive as a lower-cost energy source.

The Brattle Group, an economic research firm, projects that due to coal being sidelined, energy prices will increase $3 to $4 per megawatt-hour during on-peak hours and $1 to $2 during off-peak hours. Brattle also finds that if gas prices are forced higher, electricity prices could rise by $10 per megawatt-hour.

“It is likely that reduced supply for electricity generation, increased operating costs, and shifts in fuel demands due to retirement and retrofitting of coal plants will drive up market prices,” according to the Brattle Group’s report.

Anti-coal crusaders have helped perpetuate a big myth that coal is on its way out and has no future as a major energy source. Quite the opposite is true. Despite the Obama Administration’s attempts to wreck the domestic coal industry, demand for coal globally is strong and growing. Due to surging demand for energy in China and India, the International Energy Agency projects that coal will actually overtake oil to become the world’s top fuel within a decade.

According to the BP Statistical Review of World Energy 2013, coal is the world’s fastest-growing fossil fuel, with consumption declines in the U.S. over the past couple of years being more than offset by growth in China and other non-OECD countries.

Third World and Asian Coal
Use Likely to Continue Unabated

Tougher environmental laws in pollution-choked China could restrain coal’s ascent. But don’t bet on Asia abandoning coal anytime soon. China now consumes nearly as much coal as the rest of the world combined. The energy-hungry nation will require more coal imports in the years ahead just due to feed existing coal-fired plants (new ones are also being constructed). That could bode well for U.S. coal producers, even as the domestic market, seemingly, disappears.

The Market Vectors Coal ETF (KOL) has struggled in this difficult regulatory environment. But after declining for three years in a row, it represents one of the few areas of the stock
market that can be called cheap.

One way that China will likely try to reduce its debilitating pollution levels without shutting down coal plants is by regulating auto emissions. That will require tons more platinum and palladium for catalytic converters. Meanwhile, sales of cars and light commercial vehicles are expected to rise by 4 million to 87.2 million in 2014, according to England-based LMC Automotive. This also bodes well for platinum and palladium prices, as does the potential for more widespread adoption zero-emissions vehicles powered by fuel cells which contain platinum group metals.

The Ultimate Contrarian Play

Coal is an interesting contrarian play for 2014. While momentum players wait for confirmation of a bull market underway and miss out on the early gains, contrarians are usually early.

It’s just the nature of the strategy. Contrarians buy when they see exceptionally negative sentiment coupled with exceptionally depressed, attractive valuations.

It turns out that we were too early in identifying bargains in gold mining stocks last year. All the indicators suggested that the sector had been fully washed out in the spring. But market conditions got even worse later in the year for Market Vectors Gold Miners (GDX).

I can’t say with certainty that the final bottom is in for mining shares – though by all metrics we ought to be very close to it. But I can say confidently that the snap-back from the final lows will result in explosive gains.

Given the magnitude and duration of the decline, the rally out of it can be expected to extend for at least 3 years. Annualized gains of 65%+ for the majors and 100%+ for the mediocre juniors can be expected, with even bigger gains accruing to the highest-quality companies.

The Ultimate Safe-Haven Play

More conservative investors should favor physical bullion – gold, silver, and perhaps platinum and palladium as well. And, as always, since nobody knows the future, diversification is a must. You won’t lose your shirt if you’re well-diversified into hard assets, foreign and domestic stocks, and versatile income-producing instruments such as inflation-linked bonds.

The tables will eventually turn on the asset classes that have been bid up in sympathy with the Fed-generated faux prosperity thesis. And when the Dow falls, some of the countercyclical asset classes that have been beaten down will rise again.