NEW YORK (Reuters) - Many prominent managers at the Reuters 2014 Global Investment Outlook Summit believe the record-setting run-up in U.S. stocks is due for a reckoning but acknowledge that ample liquidity could push equities higher regardless of fears.
The S&P 500 has jumped around 26 percent this year, with major indexes notching record high after record high. Investors pointed to potential drags on the market next year, be it a pullback in stimulus by the Federal Reserve to weak earnings, that have made this market look expensive from a valuation basis.
“I’m very cautious on equities today,” said billionaire Carl Icahn, among the world’s most influential investors.
“This market could easily have a big drop,” he added.
The advance of 2013 will be hard to duplicate next year, particularly with the expectation that the Fed is going to slow its $85 billion bond buying program, which has pumped cash into global markets. However, many managers interviewed said while the market may not gain 26 percent in 2014 as it has so far in 2013, returns are likely to be positive again.
The Fed’s bond buying has helped swell its balance sheet to near $4 trillion, a record. The best chance for a correction could come when the Fed tapers its asset purchases, said Joshua Brown, chief executive of Ritholtz Wealth Management.
Icahn flagged the Fed’s flood of money as a driver behind “manufactured” earnings.
With results in from 96 percent of the S&P 500 companies, third-quarter earnings growth is estimated up 5.7 percent from a year ago. A number of analysts say companies have boosted those results by taking advantage of lower borrowing costs throughout the past year.
Borrowing costs have tumbled even for companies rated junk. Such companies pay about 4.29 percentage points more than comparable U.S. Treasuries to borrow, according to Merrill Lynch data, around a full percentage point cheaper than at the end of 2012.
“I think a lot of the earnings that you see are a bit of a mirage,” Icahn said. The earnings “are coming because you have very low interest rates,” not because of corporate strength.
Fed policymakers, including current chair Ben Bernanke and expected incoming chair Janet Yellen, say they will only reduce their bond buys in the face of a sustainable recovery.
Less quantitative easing for a stronger economy is actually good for equity markets, said Steven Einhorn, the vice chairman of Omega Advisors, who also said the Fed will take pains to soften the effects of its retreat from bond-buying.
“There are a whole host of things the Federal Reserve can do to mitigate and moderate the sting when they start tapering,” he said, such as changing forward guidance to suggest interest rates will stay lower for longer.
Einhorn expects U.S. stocks to post gains in the high single digits to low double digits in 2014. That’s in line with the views of most equity strategists who in October saw only a modest rise for stocks in 2014.
A few stocks might have overshot, but prices are not yet trading at overvalued levels, said Jeff Kronthal, co-founder of KLS Diversified Asset Management LP.
“I think at this point we don’t really have a bubble,” he said. “Certainly, you can argue individual stocks are overpriced, but I don’t really see so much in the market that says we are so out of line.”
Still, assumptions needed for views of ever-rising earnings might not be realistic, warned short-seller Jim Chanos.
“If you’re the typical investor, it’s probably time to be a little bit more cautious,” he said.
His Kynikos Associates fund is short most large leveraged coal companies in the United States and is bearish on many major oil companies, he said.
Nevertheless, continued inflows could push stocks higher. Underallocated institutional investors could chase this year’s strong stock performance and pour in money, said Todd Petzel, chief investment officer of Offit Capital Management.
“It feels to us like pensions, endowments and the insurance companies are still below their historical average allocations to equities,” he said.
Those investors have few options besides stocks to rack up necessary returns, he said. “I think a lot of people have been saying, ‘Oh gosh, this zero interest rate policy isn’t changing, I’m still not going to earn anything on bonds.’”
Retail investors could also pile in. Aaron Cowen, chief investment officer of Suvretta Capital Management LLC, called equities “the best bang for your buck.”
Assets in U.S. domiciled mutual funds - thought to reflect retail investor thinking - only recently surpassed 2007 levels, suggesting mom-and-pop investors could still have cash to deploy.
But late-entering investors could actually signal the beginning of the end for stock gains, as those buyers are “looking to play catch-up,” said Jason Ader, co-chief executive of Spring Owl Asset Management.
The CBOE Volatility Index, or Vix, earlier this year sank to its lowest since early 2007, suggesting investors are less worried about big swings in the market.
Pumped-up investor sentiment and low volatility could in fact signal a dangerous complacency.
Ader counseled patience.
“I think I’ll have an opportunity to buy the positions I want to own 20-30 percent lower if I’m patient, so I’m going to be patient,” he said. “I don’t feel the need to deploy capital just because I’ve got excess cash.”
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Reporting by Luciana Lopez; Additional reporting by Jonathan Stempel and Sam Forgione; Editing by Jennifer Ablan and Phil Berlowitz