Financial outlook for 2014.

• Author: Masson, Dubos J.

Last year we wrote about the roller coaster ride caused by the fiscal cliff and the resulting debt problems. While this "beast" is still in the picture, we predict that the 2014 financial markets will be driven more by earnings than by concerns about whether the politicians can agree with each other. However, we can guarantee that 2014 will not be as good as 2013.

In the twelve months ending November 1, 2013 the Standard and Poor's 500 index (S&P 500) rose a spectacular 25.5 percent (S&P 500 was 1,416.18 on November 1, 2012 and was 1,771.95 on October 29, 2013 including dividends). This return was dramatically higher than for the same period last year (12 percent) and is the highest since the late 1990s. The S&P 500 and the Dow are now at all-time highs and the stock market has easily recovered from the Great Recession. About half the increase over the past year was due to an increase in earnings and the other half was due to price-earnings (PE) ratios increasing. The five year return from the low point in February 2009 is a stunning 16.7 percent per year. This remarkable return occurred in spite of policy uncertainty in Washington.

The Washington dysfunction may prove beneficial for investors. With Republicans controlling the House, it is unlikely that there will be an increase in taxes or spending. Simultaneously, the "sequester" is mechanically lowering federal spending, which is now about 20.8 percent of gross domestic product (GDP) versus 22 percent in FY 2012. With the economy growing, federal taxes are roughly 18 percent of GDP. As a result, the budget deficit fell from $1.1 trillion in FY 2012 to $680 billion in FY 2013 (which ended in September). If we combine this fiscal policy with our forecasted 2 percent to 3 percent real GDP growth and 1 percent to 2 percent inflation, it results in a relatively favorable environment for investors.

With this as a background we turn to fundamentals.

Economic Fundamentals

Stock prices are a very good indicator of future economic activity: investors buy stocks anticipating the real economy will pick up in the near future. There are many positive reasons to believe this story now:

* Earnings Scorecard: Of the 374 companies that had reported earnings-to-date for the third quarter of 2013, 74 percent reported earnings above the mean estimate and 53 percent reported revenues above the mean estimate.

* Earnings Growth: Analysts are forecasting earnings will increase by about 10.9 percent in 2014...