Second-half outlook: Stocks still look better than anything else

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As the midyear approaches, many stock-market strategists are patting themselves on the back for a (mostly) well-navigated start to 2014. They called for modest gains, and the market delivered.

But now what?

Based on a few initial midyear checkups, strategists are confident that the bull market will survive – if not wow anyone with strong gains – largely because stocks still look better than everything else.

For sure, it is easy to spot some potential bumps ahead. The Federal Reserve is still tapering its monthly bond purchases and is set to consider rate hikes next year; the bull market is more than five years old and we haven't endured an official correction in years; and U.S. gross domestic product took an unexpected downward lurch in the first quarter, raising concerns about the health of the economy.

Savita Subramanian, Bank of America's head of U.S. equity and quantitative strategy, looks at stocks this way: "There is more to be gained from equities than from other asset classes," she said in a midyear outlook teleconference.

"Bonds don't look particularly attractive if we are heading into a rising interest-rate environment. And cash doesn't look particularly attractive if the Fed remains on hold [with low rates] for the next couple of years."

Stocks have something going for them though: Ms. Subramanian expects they can generate decent earnings growth of 8 per cent for the full year, driven by companies investing more money in their operations.

She is sticking with her year-end target of 2,000 for the S&P 500, implying gains of just 2 per cent from the benchmark index's close on Wednesday. However, over the next 12 months her optimism picks up, with expected gains of 10 per cent from current levels.

But investors need to be selective. She likes large-cap stocks that are exposed to the global economy – in particular, energy stocks, technology stocks and industrials.

She believes it is best to avoid stocks that investors have been buying as attractive alternatives to low-yielding bonds, such as utilities and telecom stocks, which are vulnerable to rising rates.

David Donabedian, U.S. chief investment officer at Canadian Imperial Bank of Commerce, believes that we're now in the mature phase of the bull market.

"The good news is, it's still a bull market," he said. "The bad news is that the maximum return phase of the bull market is behind us."

Now, with stocks looking fully valued, gains are going to come primarily from growth in corporate earnings. More good news: He sees earnings rising in the high-single digits this year.

But don't expect the same sort of smooth ride we saw in the first half of the year. As the Fed ends its bond-buying program and then pauses before hiking its key interest rate from zero per cent, nerves will be rattled.

"Inevitably, something will transpire that will call into question the Fed's plan," Mr. Donabedian said. "It could be bad inflation reports or an unexpected dip in the economic data."

"It doesn't mean that we're ultimately headed for hyperinflation or recession, but it will likely inject uncertainty and therefore volatility into the market."

Like Ms. Subramanian, he also likes large companies that are exposed to the global economy, but adds that it is important to focus on those with strong free cash flow.

Brian Belski, chief investment strategist at BMO Nesbitt Burns, sounds like a bit of a killjoy by comparison. He insists that the S&P 500 will end the year at 1,900, or slightly below its current level.

Even so, he frames this lacklustre second-half performance in an upbeat way: 2014 is a transition year from Fed-driven stimulus to "the fundamental realities of an improving economy."

Or, put another way, stocks could struggle after the Fed stops buying bonds, but will get their groove back when economic growth continues without central bank assistance.

"The 15 to 20 year secular bull market," he said in a note, "is very much alive."