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After a year that saw the S&P 500 soar over 30%, while bond investors suffered some of the largest losses in years, many investors are left wondering what the right path is for 2014. Is it time to trim stock exposure? Boost your cash stake? Stay the course?
We asked the editors of Morningstar's investing newsletters to share their thoughts on the New Year and where they are finding the best investment opportunities today. Below are excerpts of their responses.
Matt Coffina, Editor Morningstar StockInvestor
Investors Should Be More Discerning as Market Surpasses Fair Value
Looking ahead to 2014, the first thing I would observe is that the market is unlikely to repeat its 2013 performance. In the first nine months of 2013, the S&P's operating earnings per share advanced only 7.3%. The index's dividend yield has been hovering around 2%. That means the vast majority of 2013's returns were due to price/earnings multiple expansion rather than dividends or earnings growth.
The S&P 500 started the year with a trailing P/E multiple of 14.6 times operating earnings, which is consistent with the very long-run historical average. However, by the end of the year, the P/E multiple had expanded to 18.1. While that's on the high end compared with the past 100 years, it's about in line with the average of the past 25 years. I think there are good reasons why P/E ratios have generally been higher in recent decades compared with the past, including low and stable inflation, improved corporate transparency, and more widespread investor participation in the stock market.
Although the market doesn't look overly expensive, it doesn't look cheap, either. The median stock in Morningstar's coverage universe is trading at a 5% premium to our fair value estimate. It is one thing for the S&P's price/earnings multiple to expand from 14.6 to 18.1, basically traversing long-term and more recent historical averages. But it is quite another matter for the market's P/E to surpass 20, which would be necessary for 2014 to match the returns of 2013.
A Current Favorite From StockInvestor's Portfolios
Data as of Dec. 31, 2013
Express Scripts (ESRX)
Current Price: $70.24
Fair Value Estimate: $89
Express Scripts is one of the few health-care companies that benefit from controlling--rather than encouraging--health-care spending growth. As employers, governments, and managed-care organizations adapt to the Affordable Care Act and seek ways to make drug benefits more cost effective, Express Scripts is likely to remain a partner of choice. The company continues to flex its bargaining muscle and achieve operating cost synergies in the wake of the Medco acquisition. Express Scripts is on the opposite side of reimbursement pressure facing pharmaceutical firms: It recently excluded nearly 50 drugs from its national formulary, creating an opportunity to share in client savings. Express Scripts also generates plentiful free cash flow, and a depressed valuation should enable it to accelerate share repurchases.
Premium Members can see all of Matt's 2014 investment ideas and commentary here.
Sam Lee, Editor Morningstar ETFInvestor
It's a sad fact that investors believe assets are more attractive after rising, and uglier after declines. The opposite is true. Long-horizon investors should be wary of highfliers, and eager to embrace the downtrodden.
When the consensus is cheery, it doesn't take much of a negative shock to send prices plummeting. I worry about that today, when investors have reached into riskier assets to boost their returns. With these facts in hand, I offer some modest, long-term investing ideas for today's zero-interest-rate market.
Foreign stock markets are reasonably priced, with expected returns of 5% to 6% after inflation. The U.S. stock market, I believe, is priced to return under 4% annualized after inflation. (These are 10-year-plus forecasts, with big bands of uncertainty around them--stock markets are unpredictable in the short run, and largely but not entirely unpredictable even in the long run.) I believe investors with U.S.-equity-heavy portfolios should modestly reallocate some assets to international equities. The two best cap-weighted funds are Vanguard FTSE Developed Markets ETF (VEA) and Vanguard FTSE Emerging Markets (VWO). They're incredibly cheap and liquid.
I also like iShares MSCI EAFE Minimum Volatility (EFAV) and iShares MSCI Emerging Markets Minimum Volatility (EEMV). Both funds have quality tilts, which I believe will help them earn better risk-adjusted returns than their market-weighted counterparts. The funds are outstandingly cheap for non-market-weighted strategies, with expense ratios of 0.20% and 0.25%, respectively. I own VEA, EFAV, and EEMV (and I have none in VWO, on the belief that emerging markets are especially inefficient and better accessed through non-market-weighted strategies).
Of course, take my suggestions as a starting point for your own due diligence.
Premium Members can see all of Sam's 2014 investment ideas and commentary here.
Josh Peters, Editor Morningstar DividendInvestor, Director of Equity Income Strategy
'Tis the season for most of Wall Street's pundits to volunteer predictions for the stock market in the year to come. As usual, I will resort to my artful-dodging routine: I have no idea whether the market will go up or down, let alone by how much. After nine years at the helm of Morningstar DividendInvestor, I've lost my fear of admitting as much. Fortunately, my investment strategy doesn't require me to predict stock prices in the near term. I focus instead on both the returns and the signals that dividends provide, with confidence that a safe and rising dividend encourages long-term capital appreciation as well.
Many investors, including most professionals, try to time shifts in market sentiment--never mind that it's exceedingly hard to do. Yet the bottom line for most real-world investors is not beating the market every quarter or year, but achieving their own financial goals. By relieving us of the (unrealistic) need to obtain consistent capital gains, dividends provide an always-positive source of return to fund portfolio withdrawals in retirement or reinvest to create more future income. I don't pretend that my favorite stocks are guaranteed to lead the S&P in 2014; instead, I stick with good businesses that treat me like a valued partner with rich dividend payments year in and year out.
A Current Favorite From DividendInvestor's Portfolios
Data as of Jan. 16, 2013
American Electric Power (AEP)
Current Price: $46.58
Current Yield: 4.20%
AEP isn't quite a fully-regulated utility anymore, as Ohio (traditionally responsible for 40% of AEP's profits) has deregulated power generation. Fortunately for AEP, its deregulated plants haven't been providing much profit. If power prices don't increase, they can simply be closed, but if power prices rise in the future (as we expect) AEP gets a windfall. Meanwhile, transmission and distribution in Ohio, as well as AEP's operations in other states, retain the attractive regulatory framework where growth is driven by needed capital investment. The company's plan results in 4% to 6% annual earnings growth over the next few years, and the dividend should rise near the top end of this range thanks to a more generous payout ratio of 60% to 70% in the future. Atop a current yield of 4.2%, AEP offers solid total returns without much risk.
Premium Members can see all of Josh's 2014 investment ideas and commentary here.
Russ Kinnel, Editor Morningstar FundInvestor, Director of Fund Research
Where to Invest in 2014 and Beyond
Wow, 2013 was a great year to invest in stocks. The typical U.S. stock fund gained about 30%, and other developed markets were buoyant, too. Emerging markets had modest gains, however, and rising interest rates led to small losses for most bond funds.
Ben Inker of GMO is throwing cold water on this party. He forecasts that U.S. stocks will not even keep pace with inflation over the next seven years. He projects the S&P 500 will return negative 1.7% annualized after inflation and the Wilshire 5000 will return negative 2% after inflation. U.S. small caps are projected to have a negative 4.5% return after inflation. The crux of GMO's argument is that corporate profit margins are unsustainably high. When they revert to the mean, stock prices will trend lower, too.
If you are a stock investor, you should curb your enthusiasm and diversify. GMO isn't dumping all of its U.S. equities. Nor should you. I'll share my ideas for where you should invest in 2014 and beyond.
This time last year, I said European and Asian stocks were attractive, and I was mostly right. European stocks produced a nifty 21% return in 2013, while Japan-stock funds gained 24%. However, Pacific/Asia ex-Japan funds were flat for the year.
Europe still looks like the best place for equities, as it started off at an exceptionally low level that priced in near-disaster. The EU is expected to finally emerge from recession in 2014, and many of the savviest foreign-equity investors I've spoken to still say Europe offers superior opportunities compared with the rest of the world. With that in mind, I continue to like Vanguard European Stock Index (VEUSX) as a cheap pure play on the region.
Meanwhile, there are some great foreign-equity funds with big Europe bets that are well worth a look. Causeway International Value (CIVVX) has a Morningstar Analyst Rating of Gold and is run by Harry Hartford and Sarah Ketterer. They've produced great long-term results, yet unlike many of my favorite foreign funds, they aren't awash in assets. The fund has just $4.5 billion in assets, giving it more flexibility than most topnotch foreign-equity funds.
USAA International (USIFX) is another appealing Europe-lover that might have escaped your notice. It's run by Marcus Smith and Daniel Ling of MFS. They take a moderate-growth approach with an emphasis on high-quality stocks. Thus, the fund is a little more defensive than most growth funds. It has 71% of assets in Europe, featuring large weightings in the United Kingdom, France, Germany, and Switzerland.
Premium Members can see all of Russ' 2014 investment ideas and commentary here.
Sam Lee owns shares of VEA, EFAV and EEMV; Josh Peters owns shares of AEP; Matt Coffina owns shares of ESRX.
Morningstar.com does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.