Investors looking for opportunities in the year ahead would be well advised to forget about the strategies that worked in the year just ending.
Over the past 12 months, the U.S. Federal Reserve has held the key to markets. Its program of quantitative easing, or QE, was designed to drive interest rates to rock-bottom levels to stimulate the economy. In the process, the Fed also guided money away from fixed-income investments and into stocks and other assets.
That resulted in a perverse reaction to signs of an improving economy. Investors interpreted good economic data as a threat to the Fed's policy of monetary stimulus. Often, they would punish stocks as a result.
"Good news was bad news," said James Telfser, portfolio manager at Caldwell Investment Management. "It was incredible."
That pattern is likely to end in 2014. With the beginning of the end of QE under way, equities should once again move in tandem with the real economy, Mr. Telfser said.
Consequently, it could be challenging year for U.S. stocks if economic growth falls short of investors' hopes. "Put on your winter tires," said David Kaufman, president of Westcourt Capital Corp. "The No. 1 thing we've been advising clients at our firm is, at a bare minimum, to rebalance after they've had this fantastic year in equities. That's somewhat counterintuitive because you're selling your winners."
So, what to do with your money? Here are a few ideas.
Over the past two years, the S&P 500 has gained a whopping 45 per cent. But only a minor portion of those gains was generated by earnings growth.
While profits increased about 10 per cent, the bulk of the rally was driven by a substantial expansion in what investors were willing to pay for those earnings, said Mike O'Rourke, chief market strategist at brokerage firm JonesTrading.
"I think the whole U.S. market is expensive. I think we probably created a top in equities and they'll correct over the next year or so."
The Standard & Poor's 500 trades at 17.4 times earnings, according to Bloomberg data, up from 14.2 times a year ago. Dividend yields are also shrinking: the S&P 500 now yields 1.9 per cent, compared with 2.25 per cent a year ago.
The U.S. economy will not grow fast enough to make up for the gradual withdrawal of Fed support, Mr. O'Rourke said. "You want to be as defensive as you can."
The problem is there's not many sectors left that are obviously undervalued. Morningstar gives its highest five-star rating to just 18 stocks, the lowest tally in five years, said Matthew Coffina, the editor of Morningstar Stock Investor. "There just aren't a lot of bargains out there. There aren't the same margins of safety we've seen over the last five years."
But he does see opportunities among REITs, which have been disproportionately clobbered by fears of rising interest rates. A top pick is New York-listed HCP Inc., a health-care REIT investors have punished.
Its dividend yield sits at 5.8 per cent and its stock offers some exposure to the defensive health-care sector, Mr. Coffina said.
Investors will find little refuge in bonds, which will come under increasing pressure as interest rates rise, Mr. Kaufman said. Among fixed-income securities, he recommends high-yield bonds, which are less vulnerable to rising rates than investment grade or sovereign bonds.
Buy emerging-market equities
Investing in what Wall Street hates is often a good starting point for bargain-hunting investors, and right now few assets are so despised as emerging markets stocks.
The hype surrounding the BRIC countries – Brazil, Russia, India and China – vanished this year. Brazil's benchmark index, known as the Bovespa, is down 15.9 per cent this year, and while Indian stocks have done better, their single-digit gains (in local currency terms) have paled beside North American and European markets.
Look for 2014 to offer an attractive entry point back into some emerging markets, said Christophe Caspar, the chief investment officer for multi-strategy funds worldwide at Russell Investments.
"The timing on when to get back into emerging markets is the big question mark. If you get that right, you can make a lot of money," he said. "We've started increasing our emerging market exposure a little bit."
There could still be a few tough months ahead, but when the U.S. grows, emerging market economies usually benefit, Mr. Caspar said. Still, he recommends avoiding those countries grappling with big current account deficits – a list that includes India and Brazil.
Peter Buchanan, senior economist at CIBC World Markets, agrees that investors will have to be discriminating. He likes the potential of Indonesia.
Buy Canadian energy stocks
Canadian energy producers are also unloved. A lack of pipeline access and a surge in U.S. oil production have placed a huge price discount on Canadian oil compared with global benchmarks. Oil patch stocks have suffered as a result. The S&P/TSX energy index is still below where it was in early 2011, though it rallied in the second half of this year. It's up 9.6 per cent in 2013.
"Fund flows have really just ignored the sector. There have been more glamorous opportunities elsewhere," said Greg Newman, senior wealth adviser at The Newman Group, a Scotia McLeod affiliate.
But "over the next three to five years, with the growing world economy, oil is going to be pretty firm."
Investors have already warmed to companies such as Husky Energy Inc. and Suncor Energy Inc., Mr. Newman said. But other firms with good capital budget discipline, production growth and attractive valuations such as Cenovus Energy Inc., Canadian Natural Resources Ltd. and Enerplus Corp. have been overlooked.
Those companies have all taken a hit recently, possibly because of end-of-year tax-loss selling, Mr. Newman said, "which in my opinion makes now an ideal time to build positions."