How the Prediction Game Sets Up

 | Jan 21, 2014 | 3:30 PM EST
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The $64 million question (isn't it always) is what stocks are going to do this year. The debate is particularly hot this year after a 30% advance in the S&P 500 in 2013, along with a Federal Reserve policy that's very accommodating to equities. So what will stocks do this year? 

My answer is no better than anyone else's, because predicting what stocks will do is like flipping a coin. I can only call heads or tails -- the market will go up or down. If I'm right, I look smart, and if I'm wrong, I look out of touch. Yet each answer has a 50/50 probability of being correct.

The fate of stocks is a debate being supported by two factors: valuation and the current low-rate, low-inflation environment.

If you are in the valuation camp, stocks are generally overvalued. The S&P 500 is currently trading at 16x forecasted earnings for 2014, a rather lofty forward multiple. Most market tops have generally occurred when the S&P reaches 17x earnings, although in 1999, the S&P multiple reached into the 20s. But there can be no denying that the optimism for equities has grown greatly in past 12 months, and that can often suggest that a market top is approaching.

The other side of the argument is that as long as low interest rates and low inflation persist, the backdrop for equities will be quite good. When rates are at zero, they can only climb. And rising interest rates make bonds less attractive, thereby creating a pool of capital that needs to go someplace else. Some of that money could end up in bank accounts as rising rates make risk-free assets more desirable, meaning that the equity risk premium will go up. Yet rates are low today, and the mere anticipation that they will rise makes bond investors nervous and makes them inclined to start moving out ahead of the inevitable and put money into equities.

So what's the bet to make? If I must give you my two cents, I would say that a selective approach to stock selection today is the best policy. If you own quality securities, I'd probably sit on them unless they are at nosebleed levels -- this goes for (AMZN), Netflix (NFLX) and Twitter (TWTR). But in terms of new capital investment, look at the quality issues such as General Motors (GM), which has slid back to $38 and now yields over 3%.

Last quarter, Warren Buffett put a few billion into Exxon Mobil (XOM), which was trading at 12.6x forward earnings and yielding 2.7%. Interestingly, Exxon Mobil gives Buffett a backdoor play into natural gas, given the company's big purchase of XTO Energy several years back. I believe natural gas is a very undervalued asset today, so I regard Chesapeake Energy (CHK) as a quality market-beating pick.

If you ask what the market will do, you will find a different answer each time. You might as well flip a coin. Pay attention to valuation, and the rest will take care of itself.

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