US stocks expected to rise in 2014 despite higher valuation

Stocks in the United States have started 2014 on a softer note as analysts expect more muted returns for the year after the strong performance last year.

The Standard & Poor's 500 Index fell a total of 0.9 percent on the first two trading days of 2014 after hitting a record high of 1,848.36 at the end of 2013.

Stocks are expected to perform less well this year than last year. A Bloomberg report said that analysts forecast that the S&P 500 will climb by an average of 5.8 percent this year. This forecast is the lowest since 2005 and compares with a 30 percent gain in 2013.

“While valuation is by no means grossly overvalued, current levels suggest it may be more difficult for the market to continue its impressive run without equally impressive earnings growth,” Brian Belski, the chief investment strategist at BMO Capital Markets, wrote in a report last month.

Higher valuations may not have an immediately negative impact on stocks though. The Bloomberg report noted that following 156 quarters since 1936 in which the S&P 500 price-earnings ratio expanded, the index rose over the next three months 108 times. The average gain was 3 percent compared with 1.9 percent in all 308 quarters over that period.

However, Russ Koesterich, chief global investment strategist at BlackRock, noted in a blog post over the weekend that stocks do less well over the full year following multiple expansion. Since 1954, the S&P 500 has returned, net of dividends, an average of 5.85 percent following years when multiples expanded compared to an average return of over 10 percent in years following multiple contraction.

Furthermore, Koesterich noted that not only did multiples rise last year but interest rates increased as well. In the 14 instances between 1954 and 2013 when both multiples and interest rates rose, the average return on the S&P 500 in the following year was just 2.3 percent.

Nevertheless, Koesterich remains positive on US stocks, expecting them to “finish 2014 with a mid- to high-single digit gain”. He says that with bonds yields still low, they represent little competition for stocks, while a stronger economy this year should translate into faster earnings growth.