THE U.S. is entering 2014 with an expanding economy and a stock market at record highs. But the five-year-old bull market is showing signs of exhaustion and there could be a temporary correction around the middle of the year before the market rises strongly once again through 2015.

Overarching all this is politics as we lead up to congressional and senatorial elections in November. The public feeling right now suggests there will be a major defeat for the incumbent Democratic Party. The divisive issue is Obamacare, a.k.a. the Affordable Care Act. It has become hugely unpopular. And discontent is growing even further as more unwelcome features emerge from the labyrinthine, 2,000-page legislation.

But there also are the ongoing fiscal issues. Although Congress finally passed a two-year budget and will probably raise the debt ceiling in March, there still is no credible plan to solve the problems, so the threat of government shutdowns and/or a U.S. government default will return after the elections.

This conflict has been building for decades. The federal government habitually has spent far more than it collects in taxes. Average spending in 1973-2012 was 21% of gross domestic product (GDP) while revenue was just 17.9% of GDP. In fact, the federal debt, at US$16.7 trillion, now is roughly equal to annual GDP.

Economic growth also is on a long-term slide. For example, when looking at the peaks in year-over-year increases in real GDP, the peak for 1998 was at 5% in the fourth quarter of that year. The next high, in the first quarter (Q1) of 2004, was only 4.4%. Q1 2012’s peak was lower yet, at 3.8%. Peak growth for 2013 (in the third quarter) was just 2%.

The U.S. Federal Reserve Board is assuming GDP growth of around 3% for both this year and next, but this figure seems overly optimistic. Much of the recent production of goods went into rebuilding depleted inventories, so growth in 2014 will depend on actual sales – and many companies have been lowering their revenue guidance, which suggests they don’t expect strong top-line growth.

Corporate profits also are at record highs of around 10% of GDP after taxes, but much of the recent earnings growth came from cost-cutting – and there’s probably not much more that can be cut.

Furthermore, the secular cyclical trend in interest rates is swinging upward. Short-term rates still are at historically low levels, but the 10-year U.S. Treasury note yield was 3.03% at the end of 2013, up from a weekly average of 1.47% in 2012.

Inevitably, rates will rise further as the Fed tapers quantitative easing – its bond-purchasing program from the private sector – starting this month. How that will affect the already substandard business recovery is a matter of debate. The speed at which interest rates rise may be crucial; the Fed could lose control of the situation.

Under the circumstances, a mid-year stock market correction would not be surprising; if fact, it isn’t necessarily a bad thing, as it would set up an excellent buying opportunity.

One factor suggesting a correction is the current valuations. The average price/earnings (P/E) multiple for the S&P industrial composite index (the S&P 500 composite index, excluding financial, utility and transportation stocks) was 20.6 at yearend 2013, up from 14.6 in early 2009. A P/E level of 20 normally signals a bull-market high, although the super-bull market of 1990-2000 ended higher than 40 times earnings.

Another suggestive indicator is a series of “buying climaxes” – defined as a stock hitting a 52-week high but closing lower at week’s end – in late 2013. As well, “bullishness” reached the highest level since 2007 late in 2013 and “bearishness” was its lowest since 1987, as measured by London-based research firm Investors Intelligence.

The market is entering 2014 much as it did in 2013, with the three same sectors favoured by Standard & Poor’s Financial Services LLC‘s Capital IQ division: consumer discretionary, health care and industrials. Together, they account for 36.4% of the market, three percentage points higher than a year prior. Relative strength of these sectors also has been rising.

Here is the outlook for the 10 sectors in the U.S. stock market, from likely top performers to likely bottom performers:

Consumer discretionary is being given an “overweight” recommendation from Capital IQ. Most of the largest-capitalization stocks in this sector persist in rising trends, including Inc., Comcast Corp., Walt Disney Co., Home Depot Inc., McDonald’s Corp., 20th Century Fox Inc. and Time Warner Inc.

Outperforming industries in the sector include advertising, cable TV, footwear, housewares, retail apparel and retail Internet.

Next: Health care
Health care also is recommended for overweighting by Capital IQ, but it is less than totally bullish because of Obamacare’s unknown and still being discovered consequences.

Biotechnology, up by 73% in 2013, persists as the leading industry in this sector, with Celgene Corp., Biogen Idec Inc. and Amgen Inc. being the leaders going into 2014. Traditional, big pharmaceutical firms, such as Merck & Co., Pfizer Inc. and Johnson & Johnson, are regaining attention.

Health-care distributors outperformed in 2013 and continue to do so, with McKesson Corp., Cardinal Health Inc. and Amerisource Bergen Corp. heading this group. Health-care technology (Baxter International Inc., for example) and life sciences tools and services (such as Techne Corp., Illumina Inc. and Exelixis Inc.) are other industries with strong uptrends.

Industrials. Airlines is the industry to focus on in this sector, which is expected to outperform. After underperforming the market between 1989 and 2012, airlines have gained rapidly in relative strength – and changing industry conditions point to consistent profitability ahead. Southwest Airlines Co. is the only airline stock in Capital IQ’s “fair value” portfolio, which consists of undervalued stocks. Air freight also is strengthening.

Industrial machinery, office services and supplies, and research and development services also are gaining favour.

Consumer staples, which currently has a “market weight” recommendation, may be the sleeper sector this year. If stocks in general tumble during 2014, defensive stocks such as consumer staples will come into play. In fact, the sector is showing new signs of strength already.

On a historical yield basis, CVS Caremark Corp. has the most appeal among the large-cap stocks in the sector. PepsiCo Inc., Coca-Cola Co. and Wal-Mart Stores Inc. also are attractive on relative yield. Showing price strength are Walgreen Co., Archer Daniels Midland Co., Darling International Inc. and Constellation Brands Inc.

Information technology. The recommendation for this sector is “market weight.” A close look reveals data processing has been outperforming the market for three years. Five stocks stand out: Automatic Data Processing Inc., Convergys Corp., Fiserve Inc., Visa Inc. and Mastercard Inc. In systems software, CA Inc. is rated as “fair value” by Capital IQ, which also features Equinix Inc. (Internet software and services) as one of its top 10 stocks.

Financial services has remained flat after rising relative to the market early in 2013, and is being given a “market weight” recommendation as a result. Upon closer examination, insurance stocks continue to outperform. Capital IQ’s portfolios include Aflac Inc., Everest Re Group Ltd., Assurant Inc., Hartford Financial Service Group Inc. and Axis Capital Holdings Ltd. as well as asset-management firm T. Rowe Price Group Inc. Specialized financial services also offer opportunity, such as Moody’s Corp., Nasdaq OMX Group Inc., Medallion Financial Corp. and CME Group Inc.

Energy has been losing ground relative to the overall market since early 2011, and “market weight” is the recommendation for this sector despite the boom in shale oil and gas and a fairly firm oil price. This weakness suggests the market foresees problems. Oil and gas equipment services is the only industry showing signs of strength. Halliburton Co. is the strong large-cap stock in this group.

Materials, with an “underweight” recommendation, also has been an underperforming sector since early 2011, thanks to plunging metals and raw materials prices. There is a spark in specialty chemicals; among the large-caps in this industry is Ecolab Inc., an outperformer.

Utilities and telecom services are both dropping relative to the S&P 500 composite index and are recommended as “underweight.” The lack of popularity of these two sectors anticipates higher interest rates. The yield on the 10-year U.S. T-bill may rise as high as 3.75%, says John Murphy of As bond yields rise, prices of income-producing stocks – utilities, telecoms and pipelines – will drop to maintain competitive dividend yields.

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