Summary

To us, there are four main parts to 2014’s potential rally — the loss of QE, can Europe make a comeback, employment/data has to be strong and whether stocks overvalued after an amazing 2013 run. These four elements will definitely predict how the market does in the new year. For QE, the market will have to start to stand on its own as the Fed will likely continue to taper their asset purchases. Can the market stand on its own and how will the Fed do with unloading their assets? Is Europe going to continue to make their comeback in 2013? They need to stay strong in the coming year to help global markets. Further, we need to see strong data continue to improve as the market is going to have to stand on its own without the Fed more and more. Finally, 2013 was such a great year that many believe that stocks are overvalued and buyers are tired. We will dig into historical valuations as well as current market participation to understand that.

The Challenge of the Fed and Declining QE

The key to 2014 is going to be how the market deals with a declining amount of support from the Fed along with a large Fed balance sheet. In December, the Fed made its first reduction in asset purchases by dropping their monthly purchases from $85B to $75B. Further, the Fed has a large balance sheet as well as will have a new Chair in the new year to take over this major transition.

The Fed will continue to taper in 2014 and the pace will be predicted by the rate of economic expansion and/or employment success. The market is ready for taper, but the question is can it stand without it? Questions about the participation rate for employment as well as pace of economic expansion outside of consumer tech and housing are questioned. Further, will bond rates stay relatively flat without a lot of acceleration? In our opinion, we believe the market needs to see success in data and employment to stand on its own, but that taper could occur without it being at the levels needed. If taper accelerates too fast, it could definitely have a very negative effect on the market since that free money has provided a lot of help to the market.

Additionally, how will the transition to a new leader affect Fed policy and success? Janet Yellen is likely to be the next chairperson, and she will be pushed with the task of managing a large balance sheet, working the pace of taper, and providing a successful plan to avoid more deflation. Yellen does not seem interested in increasing asset purchases, but she has a tall task with deflation. Also, there are questions about her relationship with regulation of banks.

The big question for the year will also be how to manage the balance sheet. As the Fed tries to exit what has become $4B balance sheet, it will have to do it very strategically because as the Fed tries to bring the assets to the open market it has the potential to significantly raise interest rates, which will cause some dire consequences for the economy and equity market. The exit process is very important to the success of the market. If it is not done well, 2014 could be disastrous.

The Comeback of Europe

European markets saw a solid 2013 with Germany adding 25% in gains, France up 18%, and England up nearly 15%. The question is will the green shoots of a recovery that sprung up in 2013 take root and flourish in 2014. The European Commission noted that they expect the European economy to grow 1.4% in the coming year. That is after flat growth in 2013 and a Recession lasting several years. The coming year will see the most strength from Latvia, Germany, and likely Italy. Sweden and Britain (not in the EU) will likely see strong growth in the 2-3%. Yet, unemployment will still be strong in 2014 at likely around 11% without much improvement.

Where will European markets be headed and can they bring up other markets with them?

We see upside continuing in the year as financial stocks continue to unload bad debt and as P/Es start to normalize. Yet, it is much like the 2010-2011 period where the macroeconomic background was just moving less down and moving up only due to things expected to get better. For that reasons, we expect gains to remain in the same area of 10-20% for these markets, but we should not expect these markets to be powering American equities. Instead, strength in the USA will likely help continue to power European companies with strong consumer demand.

It will be key to watch these markets as their strength can definitely help American equities have some strength, but we would not expect European nations to power sales and profit growth overall. Yet, the continued comeback of these markets is a big question. If the countries really do shuffle their feet and fall back into recession, it will definitely challenge American markets even if the two are less connected.

Are We Overvalued?

Many have started to wonder are we overvalued and are there buyers left to push stocks higher overall. Right now, the P/E ratio on the S&P 500 (NYSEARCA:SPY ) and the Dow Jones (NYSEARCA:DIA ) are at 20.5 and 17.1. respectively. The S&P is definitely starting to push into a level that is fair valued, and it will need to see earnings to increase to continue to see upside. The DJIA, though, is not overvalued and is slightly undervalued versus the 18-20 fair value range. Therefore, we are still an area where we can see more acceleration in share valuations, but we should not expect more than 10-15%.

Before the 2009 and 2001 meltdown in the market, the S&P PE was at 66+ and 44+, so we are nowhere close to that overvaluation in the market, and we do not fear a correction in the year unless we get very weak economic data that does not support these fair value levels. These markets are like stocks of companies at 18-20. They need to see moderate growth, but they have room to improve. At the same time, they are not value names, so they need growth.

We believe that the market has 10-15% upside in 2014 as we expect to see more earnings growth as well as continued strength in the markets moving forward to attract richer valuations.

Yet, do we need a larger participation rate or is there more participation ahead. If we got more buyers entering the market, it would help push the upside potential and limit potential downside further as they enter on any drops. A great way to measure the participation rate is by inflows into mutual funds. which has hit the highest level since 2000 with over $300B in funds this year. The money has come out of gold and bond ETFs. Yet, these inflows are happening after this market has already rallied for several years. In most other times when we see this, it has happened right at the beginning or in the middle, suggesting that investors are just now starting to get back into the market. Conservative investors continue to see equities lead the way, and that is causing them to buy in on every dip.

We believe that these levels, though, are challenging because if we do not get the support from data as the Fed exits, that push that came this year will be much more of a bubble than a healthy market.

And at the end of the day after all the QE, Europe, inflows/outflows, it comes down to fundamentals. This market needs to have employment moving in the right direction, manufacturing positive, and housing continuing to be strong.

Conclusion

As we answer these questions, many still remain questions. In the best circumstance, the Fed tapers slowly and the market adjusts well. The economy continues strong and we advance GDP 3-4%. Europe stays strong and continues to rebound, and we see investors continue to flow into equities. If that happens, we are confident another 15-20% upside is in the cards. In the worst circumstance, the Fed has trouble and interest rates skyrocket. The economy moves more flat, causing Europe to double dip. Equities lose favor. In that scenario, we would see a small correction to flattish. We see something somewhere in the middle, leaning bullish for 10-15% upside in the markets next year. This is still a great time to buy as 2015 could be a rebound in strength as the Fed is out of the way and Europe really gets going. Therefore, this is a good market for buy and hold investors, growth investors, and swing traders. It, however, is not as good for commodity investors, value investors, and permabears.

Targets:

• Dow Jones — 18850
• S&P 500 — 2080
• Nasdaq (NASDAQ:QQQ ) — 4600
• Gold (NYSEARCA:GLD ) — 1150
• Oil (NYSEARCA:USO ) — 97.50

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: I have no business relationship with any company whose stock is mentioned in this article. The Oxen Group is a team of analysts. This article was written by David Ristau, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.