Stocks have come out of the gate timidly this year, with uneven performances among stocks and sectors, after roaring to a gain of nearly 30 percent last year. Such market swings are inevitable, but they invite the question: What was it that worked so well in 2013 – and can it work again in 2014?
So let’s take a quick look back at some of the biggest market phenomena that powered the rally to this point:
Growth! Growth! Growth!: Historically, value stocks outperform growth. But not in 2013. The Federal Reserve had been trying for years to persuade investors to take on more risk, and a renewed affection for growth was one of the dominant market characteristics of the year. That may have been because growth stock pricing reached appealing levels as the economy appeared poised to speed up, or, more likely, because absolute growth became more alluring than the razor-thin yields on bonds and the prices for dividend stocks. Either way, growth stocks got hot.
Netflix (NFLX) , for example, wooed investors with great growth numbers and upbeat forecasts. Investors chose to ignore the fact that it’s trading at nearly 300 times trailing 12-month earnings. Even for a growth stock, that’s rich – but it didn’t stop the company’s stock from rallying 300 percent. Amazon’s (AMZN) valuation is even more bizarre – it trades for 1,422 times trailing earnings (the market average is closer to 16) – but at least its stock price growth was more modest at a mere 55 percent.
Small Cap Growth!: A quick glance at the list of top-performing stock funds tells you all you need to know: Within the universe of growth stocks, small caps ruled. Consider Lifelock (LOCK), the Internet privacy company whose shares nearly doubled last year and now trade at about 40 times prospective earnings. True, naysayers have suggested it might be a great short sale candidate but along with cloud computing power player Logmein (LOGM), it helped power Buffalo Emerging Opportunities (BUFOX) fund to a 61.7 percent return in 2013.
Biotech: The furious debate over Obamacare may have created a headwind for financial markets and a 16-day government shutdown in October, but it didn’t put a dent in the performance of small biotech stocks, many of which doubled or did far better than that. The Nasdaq Biotech Index turned in a 60 percent gain for the year.
The good news is largely a result of research or drug breakthroughs, but that’s a double-edged sword: Big winners have rapidly become big losers, or at least proved to be exceptionally volatile. A sector to watch, clearly, but one where a 400 percent gain can be cut in half very rapidly and where diversification may pay off.
Solar Energy: So what if the United States is now heading full-tilt toward fossil-fuel independence? Solar power stocks were among the hottest performers of 2013, fueling speculation that they're in a bubble. Many-fold gains in stocks like SunPower (SPWR), which is expected to move into the black this year, can be traced to the fact that demand for solar panels is finally more in line with supply, thanks in part to lower costs and self-restraint with respect to production. Pros believe there may still be value in the sector.
IPOs: This market was as red-hot as solar or biotech stocks in 2013. That was great news for both investment banks (fees of $2.8 billion were the highest recorded since the dotcom boom of 2000) and investors (Birinyi Research notes IPOs produced $18.9 billion of profits for investors during the year). While the backlog of companies still waiting to go public remains strong heading into 2014, investors may want to move cautiously. While there are some reasonably mature and appealing businesses in that queue, the combination of investors chasing small-cap growth stocks, a robust IPO market and a strong stock market generally may tempt bankers to try the waters with less appealing IPO candidates. It happens at some point in every cycle, after all.
Indexed Investing and ETFs: One of the downsides (OK, relative downsides) for active stock pickers is that a significant number of funds simply couldn’t keep up with the S&P 500 in 2013. Whenever we see a blockbuster year for broad stock market indices, the allure of index funds rises, not only because they tend to outperform, but do so while charging us lower fees. What that means is that Vanguard rules the roost. The firm that pioneered S&P 500 index investing captured about $98 of every $100 invested in American equity funds in 2013, according to an Investment News report based on Morningstar data.
How to Play the Trends
For investors looking ahead into 2014, the trick is figuring out which trends are cyclical and which are secular – and then, if they’re cyclical, figuring out just where we are in the cycle. For instance, while natural gas prices rose 26 percent in 2013 as new sources of demand soaked up some excess supply, new production may exceed demand in the near term. That, in turn, may cap demand for solar power. The bull market for biotech stocks is a long-term trend, given the fact that big pharma companies need the kind of breakthroughs being made by these small businesses in order to help restock depleted product lines.
The biggest question mark – and the most significant for most individual investors – maybe the active versus passive debate. For those looking to gamble on active managers, here’s a possible way to do it (with a portion of a portfolio): Take active sector bets on those industries likely to demonstrate the highest earnings growth, but do so via passive vehicles like sector index funds or exchange-traded funds. Maybe – just maybe – you can have your cake and eat it, too.
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