A Strong Start to the Second Half
Economic data showing improving U.S. growth helped the market kick off a strong start to the second half of 2014. However, as evident in recent weeks, geopolitical flare-ups, European bank-related market jitters, today’s stretched valuations and relatively low market volatility leave stocks vulnerable to bad news.
We Expect the Gains to Continue
While stocks certainly aren’t cheap and the past year’s gains have outpaced earnings growth, we still believe the market will finish the year modestly higher, barring an unexpected exogenous shock, such as an escalation of violence in Ukraine or the Middle East. A stronger U.S. economy, historically low inflation and continued easy money from the Federal Reserve (Fed) should help support market gains. While the central bank is on course to end its bond buying program in October, it appears in no hurry to raise interest rates.
We Still Like Stocks Over Bonds
Despite stocks’ stretched valuations, equities remain more attractively priced than the alternatives, namely bonds and cash. However, certain areas of the market—
such as U.S. small caps and Internet stocks—appear particularly expensive, so we continue to emphasize a value bias. We suggest a focus on select market segments that offer good relative value and potential downside protection.
And We Prefer Market Segments Offering Relative Value
As for where to find value, we see it in a number of market segments, including select international markets; large and mega caps; and select cyclical sectors. In addition, given our expectation that interest rates will rise slightly in the second half, we favor munis and mortgages over certain expensive, rate-sensitive fixed income sectors.