Growth and Value

Smith noted that there are still some unknown variables when investing in natural gas. “One of the questions we haven’t been able to answer yet is whether natural gas will be used here domestically in petrochemical plants or for producing electricity through replacement of coal-fired generation,” he said. “We’re not sure whether that’s going to be the key trend over the next few years or if it’s simply going to be exported. Not only is there an arbitrage between natural gas and oil, there’s a geographic arbitrage between the U.S. natural gas markets and foreign markets.”

Although the S&P 500 performed better than expected in 2013, Smith said he expects the big issue in 2014 will be separating genuine improvements from Fed action. “We came in to 2013 with a target around 1,500 to 1,550, and that assumed earnings [per share] of about $105 on the S&P and maybe a 15 multiple,” he said. “Turned out that earnings came in a little better than we thought; it looks like S&P earnings for 2013 will come in around $109. The big factor was multiples expansion. We saw the multiple on the S&P expand by 25% last year, mostly driven by Fed accommodation. The biggest task we have in 2014 is figuring out how much is real and how much is driven by Fed inflationary efforts: teasing out what is real in the economy and what segments of the economy are actually growing due to real activity—people doing real things and selling real things—rather than simply the inflation that’s being driven by Fed money creation.”

Smith predicted the S&P will show the same low level of growth in 2014 as it did last year, with earnings per share rising from the $109 range “maybe up to $114. We don’t expect multiple expansion this year because the Fed has basically signaled they’re not going to continue shoveling money into the system at the rate they have been. We’re expecting multiples to be flat to maybe even slightly down, and a flat year for the market, maybe up 3% to 4% at the maximum, maybe a target of somewhere between 1,850 and 1,900.”

The real “wild card” for the markets this year will be China, though. “We’ve seen crazy levels of debt growth in China over the last five years. They’ve expanded their financial system the equivalent of the entire U.S. banking system over the past five years,” Smith said. Unfortunately, a lot of the money that was created was “not for profit-making purposes; it was mostly created to generate statistics that you could show to the central party and make your region look good.”

Consequently, “the Chinese central bank has a choice to make as to whether they’re going to continue to flood the system with liquidity and keep this bad credit from failing, or finally a day of reckoning will come and they’re going to have to admit that they’ve got some problems in their system. We think that’s probably going to happen this year.”

Whatever happens in China, investors here have to be prepared. “China’s still the biggest auto market in the world. They’re the biggest steel manufacturer in the world, the biggest importer of gold, the biggest importer of oil, biggest producer of coal. When fundamentals deteriorate there, it’s going to be something we need to pay attention to here,” Smith stressed.

It’s not all bad news, though. “The counter to that, and it’s something that’s not really talked about very much in the press yet, is the significant improvement in the U.S. fiscal situation. Fiscal year 2012 we had a $1.1 trillion deficit. Fiscal ‘13 it sank to about $660 billion. If you prorate what we’ve seen in the first few months of the fiscal year through September, it looks like the deficit could come in under $400 billion, which would be about 2% of GDP, which is a pretty normal level.”

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Correction: The print edition of this article misstated Fort Pitt’s initial minimum investment as $250 million. The correct amount is $250,000. This article has been corrected to reflect that change.