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Outlook on 2014: Soaring stocks, government gridlock worry wonks

Buy low, sell high.

The most intuitive investing strategy may be the most successful in the long run, but it's never easy to follow—particularly as stock indexes continue climbing to record highs.

"No one ever wants to rebalance their portfolio [when markets are rising]," said certified financial planner Mark Cortazzo, senior partner at advisory firm MACRO Consulting Group. "It just feels wrong."

Andrew Olney | OJO Images | Getty Images

Cortazzo said he remains "cautiously optimistic" about the equity markets but is nevertheless pushing his clients to rebalance their portfolios and even buy protection for them. "I worry that people have lost their respect for risk," he said. "It hasn't rained in a while, so people are throwing away their umbrellas. A 20 percent correction in the equity markets is going to happen. It's only a matter of when."

(Read more: Boldest predictions for 2014)

There is reason for optimism. The outlook for the U.S. and global economies is the best it's been for years. American consumers are in better financial shape, the worst of the government sequestration is behind us, and the corporate spending cycle is likely to turn this year.

David Grecsek, director of investment strategy at wealth management firm Aspiriant, believes the U.S. economy is approaching "Goldilocks" status—strong enough to sustain corporate earnings momentum but not so strong that it ignites still-muted inflation.

"We've seen a deceleration in global economic growth, but it's going to get better in 2014, and it's going to be led by the U.S.," Grecsek said.

(Read more: Don't expect big things from D.C. in 2014)

The question is whether the markets have already priced in all the good news. The nearly 30 percent rise in the S&P 500 index last year, along with the general strength of stock markets across the developed world, has advisors and investment strategists anxious heading into early 2014. While the improving economy may backstop further gains in stocks, the risks are now much greater and the opportunities much less apparent.

"I don't think the U.S. stock market is in bubble territory, but it's not cheap," said Russ Koesterich, chief investment strategist for asset manager BlackRock. "It's hard to find anything unambiguously cheap at this point."

Fixed income and the Fed

That's particularly true in the fixed-income markets. Investment experts almost universally agree that interest rates will continue to rise from their still historically low levels—albeit at a gradual pace. With the economy showing signs of increasing strength and the Federal Reserve Bank starting to taper its $85 billion monthly asset-purchase program in January, long-term rates will trend upward and the yield curve will further steepen.

The 10-year Treasury bond is likely to have another poor year in 2014, and with a still-paltry nominal yield just above 3 percent, investors looking for more income are going to have to take on risk to get it.

(Read more: Bob Pisani's predictions for 2014)

"Low interest rates on safe yields continue to be one of our biggest concerns," said certified financial planner Barry Glassman, president of Glassman Wealth Services. "If rates do what they did in the second quarter of 2013 again, investors [in the 10-year Treasury] could lose two to five years' worth of yield."

Glassman is taking on the credit risk of short-term high-yield debt rather than the interest-rate risk of higher-quality, long-term bonds. He's also putting more fixed-income money into nontraditional bond funds that can go anywhere and even short Treasurys.

"We think it's very likely we'll have a pullback in the U.S. stock market. It's at the top of our client worry list." -Gina Beall, lead investment research analyst, Savant Capital Management

Mike Ryan, chief investment strategist for UBS Wealth Management Americas, is similarly favoring credit over duration risk, preferring high-yield and investment-grade debt to Treasurys. He also likes tax-free municipal bonds that have sold off after the Detroit bankruptcy filing.

"The muni market tends to overreact in periods of repricing," Ryan said. "Credit conditions are improving for issuers."

For his part, Grecsek at Aspiriant thinks tax-advantaged master limited partnerships (MLPs) in the energy sector can still produce attractive income streams for investors. "MLPs have appreciated in price, but we think investors will still be interested in this low-yield environment."


Soaring stocks

The U.S. market has come a long way since bottoming out in early 2009. The S&P 500 index has now risen to nearly 1,850, up from under 700 in March of that year. And—apart from a 15 percent swoon after the first showdown on the federal debt limit in 2011—the market has not had a major correction in nearly five years.

"We think it's very likely we'll have a pullback in the U.S. stock market," said Gina Beall, lead investment research analyst for advisory firm Savant Capital Management. "It's at the top of our client worry list."

That said, Beall thinks better corporate earnings can support the higher valuations and that U.S. stocks still have room to move higher. She doesn't favor specific sectors in the economy but has a strategic tilt toward small-cap value stocks, although somewhat less so than in the past, given the recent strength of small caps.

(Watch: Look out for these stocks in 2014)

Glassman is more cautious.

"The market has soared, but revenues, earnings and the economy have not," he said.

He sees a bifurcated market where already expensive stocks, such as Tesla (TSLA), LinkedIn (LNKD) and Netflix (NFLX), have gotten even more so compared to others, and he is favoring long/short funds that can invest on both sides of the market. "One way to address a bifurcated market is to short the overpriced stocks and go long [on] the reasonably priced ones," Glassman said.

The most obvious buying opportunity in equities is in emerging markets, say most advisors. Emerging markets have only just begun to recover from the sell-offs that followed investor scares about U.S. fiscal and monetary policy. "The emerging markets have been the ugly ducklings out of favor with investors," said Cortazzo. "We're now slightly overweight the sector."

Aspiriant's Grescek added that "as the U.S. goes, so goes the rest of the world. But we see more long-term opportunity in fast-growing emerging markets."

(Read more: Have you reviewed your 401(k) recently?)

According to BlackRock's Koesterich, current geopolitical flashpoints such as Ukraine and Thailand could scare the market, but he thinks emerging Asian markets are a buying opportunity. "People have to go outside their comfort zones," he said.

Washington wild card

Whether it is fatigue or sheer boredom, investors seem to be getting used to the recurring political drama in Washington over budget and debt issues. It wasn't exactly the Grand Bargain, but President Obama recently signed a two-year bipartisan budget deal that averted another potential government shutdown in January. There is still a potential showdown looming in February over raising the debt limit for the federal government, but financial advisors expect the markets will not be as jittery about the outcome this time around.

"I think it's going to be a sideshow, not the main event," Grecsek said.

The main event is the unwinding of the Fed's ultraloose monetary policy. The Fed, under incoming chairwoman Janet Yellen—expected to be confirmed this month—is likely to keep short-term rates near zero for some time.

However, the central bank announced a $10 billion reduction in its $85 billion monthly bond purchase program for January and is expected to further taper its purchases in the coming months. So far, investors have cheered the relatively modest change in policy, but they may get spooked by more reductions down the road.

(Read more: Four ways to make money off of Washington)

"There's no precedent for this. The Fed is an unnatural buyer in the market, and it's distorting the natural supply and demand for investments," Cortazzo said. "The best thing might be to rip the Band-Aid off, but no one wants to hurt the kid."

With asset valuations as high as they are, it's a good bet that the "kid" could get unruly—however smoothly the Fed executes the change in policy.

"I don't know when we'll see a correction, but we're preparing for greater volatility this year," Glassman said.

—By Andrew Osterland, Special to CNBC.com

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