US stocks had a spectacular run in 2013—delivering their best annual performance in more than a decade. At current levels, stocks are not cheap but they are not too expensive either. An improving economy, receding fiscal drag and an accommodative monetary policy should support further gains in stocks though gains will most likely be nowhere close to last year’s. (Read: 3 Hot Sector ETFs for 2014)
The Fed starts ‘tapering’ its asset purchase program this month and may announce further reductions at a "measured pace” this year if the economy and the labor market continue to improve.
With interest rates on the rise, the three decade long bull market for bonds has come to an end. The US bond market as measured by the Barclays US Aggregate Bond Total Return Index had a 2% decline in 2013. The losses may accelerate this year, particularly for long term treasury and mortgage bonds.
As we head into 2014, it may be a good time to look at your portfolio and realign it according to the changing investment landscape. (Read: 3 Best Dividend ETFs of 2013)
Top Sectors for 2014
Sectors like Technology, Industrials and Financials outperform in the improving economic and rising rate environment. Technology sector has remained mostly out of favor with investors last year due to several industry-specific issues and less-than supportive global macroeconomic environment. At current valuations, the sector looks attractive. Continued pick-up in the manufacturing activity bodes well for Industrials.
Among Financials, Banks—Regional Banks in particular—benefit from the steepening yield curve while Insurance companies benefit from rising rates as well as brightening economic picture. Consumer discretionary stocks had an excellent run in 2013 but they may continue their uptrend if the job market continues to heal. (Read: Follow Warren Buffett in 2014 with these sector ETFs)
Some of the top ranked ETFs from these sectors like iShares Industrials ETF (IYJ - ETF report) , Vanguard Information Technology ETF (VGT - ETF report) and SPDR S&P Insurance ETF (KIE - ETF report) are worth considering.
On the other hand, bond-like sectors including Utilities, Telecom and REITs will suffer setbacks if interest rates continue to rise.
Recovery in Europe and Japan may gain Traction
The Euro-zone is slowly coming out of its long recession, and though the recovery may gain further momentum in 2014, it may still remain imbalanced between different members. Germany, Ireland, Italy and Spain look better positioned as of now in addition to UK and Sweden outside the zone.
After a massive surge in early 2013 and a rather moderate performance in the second half of the year, Japan hedged ETFs may be ready for the second phase of their bull-run this year. (See: Japan ETFs—One year after Abenomics)
With the US dollar on the bullish trend, currency hedged ETFs like db X-trackers MSCI Germany Hedged Equity Fund (DBGR - ETF report) and WisdomTree Japan Hedged Equity Fund (DXJ - ETF report) look interesting this year.
Will Emerging Markets ETFs Rebound?
Emerging Markets ETFs had a rough time in 2013 mainly due to rising worries about the end of the era of cheap money. Though most of these markets look attractive in terms of valuation now, investors will need to take a hard look at macroeconomic fundamentals as well as political situation in these countries before deciding to invest. (Read: 3 Emerging Market ETFs to watch for Political Issues)
Emerging markets that depend on external capital flows to finance their wide current account deficits like Indonesia, Brazil, Turkey, India and South Africa remain vulnerable to QE ‘tapering’. Further, all these five countries will hold general elections this year, leading to higher volatility. Ongoing political unrest in some of emerging countries will continue to cause turmoil in the markets.
On the other hand countries like Mexico (EWW - ETF report) , South Korea (EWY) and Taiwan look attractive not only due to their sound macroeconomic fundamentals and lower dependence on ‘hot’ money but also since these countries will benefit a lot from the economic pick-up in the US. (Read: Will Mexico ETF Shine in 2014?)
Some Niche Strategies may Continue to Crush the Market
ETFs provide easy access to many ‘niche’ strategies that have been consistently crushing the broader market. (Read: 3 Niche Strategies Crushing the Market)
Some of these strategies may continue to reward investors in 2014. US companies have been buying back their stocks at a record pace. Per S&P, share repurchases increased to $128.2 billion during Q3 2013, up 8.6% from Q2 and up 23.6% from Q3 of 2012.
With record amount of cash on their balance sheets, US companies may continue to increase their share repurchases in the months to come and PowerShares Buyback ETF (PKW - ETF report) remains a solid pick for 2014.
I also expect that only “high-quality” stocks will outperform as the QE support is slowly withdrawn by the Fed. Investor could take a look at iShares MSCI US Quality Factor ETF (QUAL - ETF report) and Barron’s 400 ETF (BFOR - ETF report) for getting exposure to a diversified basket of companies with solid fundamentals.
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