What Professional Investors Expect in 2015

As we close the book on 2014, how should you tweak your portfolio for the year ahead?

On the whole, the U.S. economy has been looking better of late. Financial experts point to falling unemployment, rising stock prices and an uptick in housing starts as evidence. Third-quarter GDP grew a surprisingly strong 5%.

That has prompted rumblings that things might have peaked and may soon be heading downhill. But that notion might be unfounded, say experts.

“There is a strong consensus that the global economy is fading” and might enter a deflationary spiral, says James Paulsen, chief investment strategist at Wells Capital Management. “I would bet against that.”

Alan Zafran, managing director of First Republic Investment Management, is also bullish.

“I would tell investors to take a deep breath,” he says. “Stay the long-term course. And stay diversified.”

By some metrics, U.S. stock valuations are relatively high, financial experts say. The S&P 500 index recently traded at a price/earnings ratio of 19.5, up from 18.6 a year ago and a historical average of 15.5, The Wall Street Journal recently reported. Mr. Zafran acknowledges that for 2015, “we’re looking at lower rates of return across most asset classes.” We can expect to see total returns (price gains plus dividends) compounding at about 7% to 8% over the next two to three years, he says—lower than the historical average of about 10%, but decent.

Investors should be discerning, and look to companies in robust financial health, says Darren Pollock, portfolio manager at Cheviot Value Management. “Companies with strong balance sheets and relatively stable growth profiles can provide investors with better downside protection while still performing well in a rising market,” he says.

Mr. Pollock adds that investors shouldn’t feel compelled to be aggressively invested at the moment. “Investment-grade short-term bonds and money-market funds are a fine parking space for investors who want available ammunition for bargain hunting should the market provide intelligent opportunities in the year ahead,” he says.

And though financial experts are quick to remind us they can’t predict the future, there seems to be a consensus on key factors that will influence market activity next year—if not on the direction of that influence.

“Everyone’s talking about rates, the dollar and oil,” says Adam Parker, chief U.S. equity strategist at Morgan Stanley.

Interest Rates

The Federal Reserve has signaled that it plans to raise interest rates, phasing out easy-money policies designed to stimulate a faltering economy in the wake of the 2008 financial crisis. But the Fed’s timeline for doing so remains unclear, and financial experts are split on whether rates will actually go up in 2015.

Mr. Paulsen of Wells Capital says investors should prepare for rising interest rates and bond yields next year. He predicts the markets will “start to look at good news here as bad news”—that is, the recent balmy U.S. economic climate will serve to “accelerate and make more aggressive the Fed’s need to raise rates,” which will affect both stocks and bonds, he says.

So it might be a good time to “lighten up on fixed income,” moving toward the lower end of your preferred allocation range for the asset class, he suggests.

Other experts say it might take longer for rates to increase. “We believe that the Fed won’t act aggressively if/when it raises interest rates,” says Mr. Pollock in emailed comments. “Interest-rate policy will remain accommodating throughout the year,” he adds. Furthermore, Mr. Pollock says the rotation of voters on the Fed’s 12-member Federal Open Market Committee—the group that decides on interest-rate policy—is set to lose one of this year’s two hawks and add a fifth dove in 2015.

Morgan Stanley’s Mr. Parker says the Fed won’t act until 2016, so “it is too early to be really bullish on rate-sensitive securities.” Historically, he adds, the market has rallied during the first Fed action.

The Dollar

Mr. Zafran says the dollar is poised to strengthen next year, citing U.S. economic stability relative to volatility abroad. Europe is on the verge of a recession, he says. Japan is in one, and China’s growth is slowing.

Given the significant stimulus measures central banks are taking in Japan, China and elsewhere, it makes sense to have some exposure to international markets now, he says. “Non-U.S. markets are more attractively valued with higher dividends” than U.S. markets at the moment, he says.

Mr. Paulsen agrees that investors should look abroad in 2015. “I would diversify away from the U.S.” because emerging-market stocks are “really cheap based on fears that are probably overblown,” he says.

Oil Prices

Plunging oil prices mean it is a good time to load up on energy stocks, say financial experts.

“It is our view that every time energy stocks have underperformed this much, they’ve outperformed in the next six months,” Mr. Parker says.

Though Cheviot’s Mr. Pollock is also bullish on energy stocks in the long term, he cautions against picking them up too quickly.

“Oil prices will continue to fluctuate and may have more surprises in store,” he says. “We recommend not going all-in at once. Investors should remain flexible enough to buy more of the top-tier integrated oil companies should their prices fall further.”

Growth Sectors

Among other sectors offering growth opportunities next year, Mr. Parker recommends stocks in the so-called discretionary category, a catchall for goods on which consumers spend after-tax income not needed for food and other essentials. It includes cable and satellite media, autos and some retailers, he says. But it might be time to dump stocks that fall into the utilities and staples categories, he says.

The tech and financial sectors are also poised for growth next year, writes MarketWatch columnist Jeff Reeves. Mr. Reeves notes that tech ETFs outperformed the broader market this year, a trend that could continue.

Robust lending led to an 18% uptick in earnings for the financial sector in the third quarter, he writes. With higher interest rates on the horizon, he notes, margins for loans could soon be on their way up.

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