The market is entering 2014 in a very good place. The economy is continuing to recover, the Federal Reserve is reducing its stimulus, corporate earnings continue to look comforting and consumers are slowly becoming more confident. All of these factors create a solid underpinning for a rising a stock market -- and it doesn't hurt that the low interest rates make equities a more tempting asset class.
But the market is forward-looking creature, and Mr. Market is not dumb. There's a reason why the U.S. indices were up more than 30% in 2013. You can argue that a lot of the wonderful economic trends in 2013 are already built in, though many of those trends could continue creating further gains. The market is running at full steam, prices are elevated and many investors are getting excited.
Such excitement tends to favor the fast runners and to ignore high-quality, stable issues. I, therefore, would focus on the latter.
More to the point, some of the highest-quality stocks remain the most attractive investment opportunities today. Quality often confers cash flow and profit, the factors that drive investment gains. While people chase Twitter (TWTR), you should be looking at names like Exxon Mobil (XOM) and Microsoft (MSFT), which are generating gobs of cash, repurchasing stock and making dividend payments. High-quality names can weather the storms -- and they also tend to be able to manage ably in weaker conditions. That financial and operational ability can mean less volatility.
In that vein, the value of quality may also come out during periods of pessimism -- and that is precisely when Mr. Market tends to assign higher multiples to more stable businesses. Today, stocks in the S&P 500 are valued at an average of nearly 18x trailing earnings. Yet you have names like Deere (DE) at 8x earnings, Exxon Mobil at 13x and Microsoft at 13.5x. Others, like Wells Fargo (WFC), trade for 12x earnings.
Tucked inside the spectacular triple-digit gains from such names as Facebook (FB) in 2013 were very nice returns from quality stocks. Many of these names outperformed the S&P, and they are likely to do so in 2014. Indeed, an improving economy could likely have a disproportionate positive effect on the strongest, deepest businesses. That effect could trigger similar response in the underlying equity price.