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A choppy start to 2014 underscores the need to play defense, say market veterans.
Many portfolio managers are shifting away from the kinds of investments that did exceptionally well in 2013 but are vulnerable to large swings. For some, that means paring back on U.S. small-company stocks in favor of shares of large companies with growing dividends. Others are focusing on shorter-term bonds based on expectations that rising economic output will lead to higher interest rates.
The S&P 500 index (.SPX) gained 30% last year, amid an improving U.S. economy and exceptionally loose Federal Reserve policy. Even more remarkable to many observers was that declines in the stock market were generally short and shallow. Accordingly, many investors entered 2014 expecting a slower advance marked by rocky stretches — a forecast that has been borne out by a 5% decline in the Dow Jones Industrial Average (.DJI) since the beginning of the year.
After last year's big rally in stocks, the market this year might gain "8% to 10%, but it's going to be a hard 8% to 10%," says Robert Smith, chief investment officer at Sage Advisory Services, which manages $10 billion out of Austin, Texas. "Investors are going to have to be really careful."
Tumult in emerging markets has been the catalyst for the recent bout of indigestion, along with the Fed's steps to pare back stimulus known as quantitative easing.
When the central bank was pumping $85 billion a month into financial markets last year through purchases of bonds, extremely low interest rates—and expectations they would stay low—gave investors more confidence about taking on riskier investments.
But the Fed has set plans to trim its monthly purchases to $65 billion and has signaled that it expects further cuts in 2014. Many investors say the pullback is reducing demand for some assets and boosting volatility, or price swings.
In January, the S&P 500 averaged daily stock swings of plus or minus 0.6%. That is an 11% increase over the average daily move in 2013.
"I expect a lot of up and down in the first half of the year," said Wayne Wilbanks, chief investment officer at Wilbanks, Smith, Thomas, which manages about $2.5 billion out of Norfolk, Va.
In particular, Mr. Wilbanks likes big technology companies that pay dividends, such as Cisco Systems Inc. (CSCO) and Apple Inc., (AAPL), and industrial dividend payers such as Caterpillar Inc. (CAT) and Deere & Co. (DE), he said. All four lagged behind the market last year, leaving them less vulnerable to additional declines, Mr. Wilbanks said.
Cisco Systems rose 14% last year, about half as much as the S&P 500. Deere rose 5.7%, Apple 5.4% and Caterpillar 0.5%. The dividends, together with the small increases last year in the companies' share prices, reduce the risk of steep declines in the investments, Mr. Wilbanks said. Deere stock "hasn't gone anywhere, but it certainly isn't going to hurt you to hold," said Mr. Wilbanks.
Barry James, president at James Investment Research Inc., which manages about $5 billion in assets, said he wouldn't be surprised to see stocks fall as much as 20% during the year and recover to finish slightly higher.
Mr. James said he looks for stocks with strong earnings, and that return cash to shareholders through share buybacks and dividends. He likes Deere and the U.S. energy sector, which he thinks will benefit from continued development of the U.S. industry for shale oil and gas.
"I feel like a football coach," he said. "Back to the fundamentals, kids."
Investors across markets are taking a more risk-averse stance this year.
Investors yanked more than $900 million from bond funds dedicated to the risky corporate debt known as "junk" bonds in the week ended Wednesday, according to fund tracker Lipper. That was the biggest outflow since late August.
January had 110 high-grade corporate debt issues, down from 206 a year earlier, according to data provider Dealogic, amid signs that investors are starting to demand more compensation.
"As you dismantle quantitative easing, you dismantle a lot of the free ride," says Sage's Mr. Smith.
For Mr. Smith, whose firm has a heavy emphasis on fixed-income portfolios, that means a tilt away from bond investments that are vulnerable to rising interest rates. The firm is focusing on short-term bondholdings and high-yield bonds that haven't had as big a run as the overall junk-bond market in the past year, such as bonds issued by utilities.
But in a sign of how the market has wrong-footed many investors this year, the yield on the 10-year U.S. Treasury note actually has fallen to a recent 2.7% from 3% at the end of 2013. Many Wall Street forecasters expect the yield to rise to 3.5% or so this year. Prices fall when yields rise.
Lawrence Creatura, portfolio manager of the $500 million Federated Clover Small Value Fund (VSFAX), said last year's market calm allowed for a big expansion of stock multiples, meaning an increase in the ratio of stock prices to earnings.
Stock multiples last year expanded the most since 2009, when the market was recovering from the depths of the financial crisis. The price/earnings ratio on the S&P 500 over the next 12 months rose to 15.4 from 12.6, according to FactSet.
Mr. Creatura said he is looking at the technology sector, which he said should see strong growth as companies upgrade internal infrastructure.
"In the middle innings of an economic cycle, earnings growth should come from more-cyclical sectors like technology," he said.
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