Another banner year? Maybe not. Photographer: Jin Lee/Bloomberg
Another banner year? Maybe not. Photographer: Jin Lee/Bloomberg

(This is the third in a four-part series. )

Despite a robust market in 2013, and a recovery in February after sharp losses in the first month of 2014, there are considerable questions about stock performance this year, even in the absence of a shock.

Will price-earnings ratios, which accounted for two-thirds of the 30 percent increase in the Standard & Poor's 500 Index last year, continue to rise? Equity investors expressed concern last spring when the Federal Reserve first discussed exiting from quantitative easing. But investors weren't bothered when the central bank began to cut its asset purchases in December. Will they maintain that serenity as the Fed accelerates tapering this year? What will be the effect on the profits of multinational companies if the dollar continues to rise, undermining exports and the value of foreign earnings?

Until recently, the strength in U.S. stocks had almost exclusively been produced by rising profit margins. Low economic growth has severely limited sales-volume growth, and the absence of inflation has almost eliminated pricing power. As a result, businesses have cut labor and other costs to achieve bottom-line growth.

The S&P 500 reached an all-time high in February, but corrected for inflation, the stock market remains in a secular bear market that started in 2000 and is 10 percent below its peak in August of that year. This reflects the slow economic growth since then, and it is consistent with the long-term pattern of secular bull and bear markets. In secular bear markets, the price-earnings ratio on the S&P 500 declines to less than 10 from more than 20. At the 2000 peak, the price-earnings ratio was 28, based on earnings in the previous 12 months. It is 18.6 today.

Other warning signs include the high level of stock-market capitalization in relation to gross domestic product. At 141 percent, it’s almost back to the mid-2000s housing-bubble peak of 144 percent, which was only surpassed at the end of the dot-com bubble in early 2000, when it reached 174 percent. Furthermore, betting that the stock-market rally will persist, investors are shifting toward stocks with low price-earnings ratios. Sector rotation often occurs at market peaks.

Nevertheless, the current environment is “risk on,” and my investment themes for 2014 take this into account -- even if my list is defensive:

• Treasury bonds: My interest in Treasuries could be questioned in view of their decline last year and the likelihood of further Fed tapering. Most investors look for higher yields, especially since the 10-year Treasury note yield breached 3 percent in late December.

But in 1981, few people agreed with me that serious inflation was unwinding and that interest rates would fall. Then, the consensus called for rates to remain high or even rise indefinitely. Yet when 30-year Treasury yields peaked at 15.21 percent in October of that year, I said inflation was on the way out and that we were “entering the bond rally of a lifetime.”

Later, I forecast a drop to a 3 percent yield; then, too, many forecasters thought I was crazy. And my prediction of declining Treasury bond yields has been continually challenged, even though yields have fallen on balance for more than three decades. Beginning in 1981, a 25-year, zero-coupon Treasury, rolled into another 25-year bond annually to maintain the maturity, beat the S&P 500 by 5.5 times on a total return basis.

Here's why I continue to favor Treasury bonds:

1) The U.S. will experience economic growth of 2 percent at best in coming quarters.

2) Deflation is looming.

3) Long Treasury bonds are attractive to pension funds and life insurers, which have long-term liabilities.

4) Treasuries are a haven from global turmoil.

5) The Fed may well extend its tapering program in response to persistent weak employment and sluggish economic growth.

In January and February, Treasury bond prices jumped 7.2 percent as the yield fell to 3.59 percent from 3.96 percent.

• High-quality income-producing securities: Corporate bond yields rose last year as the Fed signaled it was considering tapering. They have stabilized, even though a record $1.111 trillion in investment-grade corporate bonds have been issued, up from $1.053 trillion in 2012, as borrowers anticipated rising interest costs. Also, the growing appetite of investors for safe income is narrowing the spread between such assets and Treasuries. Predictable dividend-paying stocks -- utilities, for example -- may do well in 2014.

• Consumer staples and food: These investments tend to have stable earnings and meaningful dividends. Items such as laundry detergent, bread and toothpaste are bought in good times and bad. The S&P 500 Consumer Staples Index was up 23 percent last year, more than double its gain in 2012. Many of these companies also pay attractive dividends.

• Small luxury goods: Consumers strive to buy the very best of what they can afford. Last year, my firm's index of companies involved in small luxury goods -- such as premium beer and liquors, perfumes, high-end clothing, jewelry, home products and handbags -- was up almost 52 percent. I look for additional gains.

• The dollar: The U.S. currency will continue its rise against the yen as Japanese Prime Minister Shinzo Abe continues his policy of depreciation. The greenback also will rise against the Canadian and Australian dollars as declines in commodity prices continue to depress those currencies. The American dollar will get more help as U.S. growth continues to exceed that of most other developed countries.

• Japanese stocks: These equities should continue to benefit from the weak yen, which helps Japanese exporters, and by the Abe government’s efforts to spur growth. The Nikkei 225 Index rose almost 57 percent last year.

• Health care and medical office buildings: The Affordable Care Act, despite its troubled rollout, and the medical needs of aging members of the baby-boom generation will power growth in these areas.

• Producers of productivity-enhancing hardware and software: These companies will continue to benefit from businesses' zeal for cost cutting as a response to slow revenue growth, lack of pricing power and currency losses. Last year, the S&P 500 Information Technology Index rose 26 percent.

• North American energy: Attractive investments include drillers, suppliers, pipelines and exploration-related activity. The gradual opening of Mexican energy production to foreign investment will eventually benefit U.S. companies with expertise in deepwater drilling, hydraulic fracturing, horizontal drilling and other sophisticated techniques.

I advise avoiding renewables such as solar, wind and thermal energy because they are too dependent on uncertain government subsidies.

• Commodities: This asset class will remain unattractive as prices continue to fall. This includes industrial materials such as copper and aluminum, which are hampered by excess output in the 2000s and limited demand growth. Grains, soybeans, sugar, coffee and other agricultural commodities have also seen big production increases and are likely to be subject to further price declines, barring unusual weather patterns.

• Emerging-market equities and bonds: With notable exceptions such as South Korea and Mexico, the appeal of most emerging-market stocks and bonds evaporated when the Fed began to discuss tapering in May and June. These investments will most likely remain under pressure. This is especially true of economies that have current account deficits, high inflation, weak currencies and a recent history of falling stock prices.

(Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the third in a four-part series. Read Part 1 and 2.)

To contact the writer of this column: Gary Shilling at insight@agaryshilling.com.

To contact the editor responsible for this column: Max Berley at mberley@bloomberg.net.