As we leave an unexpectedly banner year for stocks behind and head into 2018, the big question for investors is whether the second longest bull market in history (only eclipsed by the dot-com era bull that ended in 2000) will continue to roll on and register its 10th consecutive year of positive returns? Or, are we at or near a market top?
With the S&P 500 in the midst of its longest stretch on record without a meager 3% correction, it’s highly unlikely that 2018 will be another “all gain and no pain” year. However, there is reason to believe that global equity markets have further room to run before succumbing to the next bear market.
With the global economic expansion on reasonably solid footing and U.S. corporate and personal tax cuts going into effect in 2018, a near term recession is not a highly probable scenario. Barring an unexpected shock (i.e. a military conflict with North Korea), growing corporate profits, low unemployment, deregulation, and stronger consumer spending should continue to buoy the economy and provide a tailwind for the equity markets. Furthermore, the economic fundamentals in many developed and emerging markets are improving with their economies in an earlier phase of expansion than the U.S., providing a favorable backdrop for rising profits and share prices.
Investors should continue to stick with targeted equity allocations, including an allocation to non-U.S. equities, but look to take profits from the soaring large cap growth sector (dominated by technology stocks). Increasing exposure to large cap value stocks, including financial, energy, and industrial stocks, may have merit as those sectors tend to do well in later stages of the business cycle when the Fed is raising interest rates.
Despite the potential for more gains, investors should not be surprised by a long overdue market correction in 2018, perhaps triggered by rising interest rates or mid-term elections. Maintaining a short to intermediate term core bond position, and incorporating an allocation to funds with less volatile, alternative strategies should help portfolios stay on track during any market turbulence ahead.
Earnings Look Good…Valuations Not So Much
Rising corporate profits are the lifeblood of any sustained bull market and with U.S. corporate profits set to jump 16% from 2017’s level, what’s not to get excited about? The issue is that corporate profits are just one essential part of the market value equation. The other part is how much investors are willing to pay for those profits, which is reflected in the market’s price/earnings (p/e) ratio.
For the last several years, the p/e ratio for the S&P 500 has steadily risen as investor sentiment continues to grow along with earnings. The S&P 500 is now valued at roughly 22x 2017’s earnings and over 18x next year’s forecasted earnings which is a premium to the 16x long term p/e average. Sure, valuations can remain extended for a long time, but counting on further p/e multiple expansion from here is unrealistic and a sign of a bubble. However, if multiples can hold current levels, the market can deliver another double-digit year of returns as long as expected profit growth materializes. However, earnings growth, coupled with a contraction in the p/e multiple could result in a more flattish year. Regardless, the further stretched valuations become, the more vulnerable the market becomes to disappointment and negative surprises.
Tax Cuts Provide Some Relief
Eager to get a win under their belt in 2017, Congress passed and Trump signed the Tax Cuts and Jobs Act of 2017 on December 22nd. At a cost of roughly $1.5 trillion dollars, the Act, which lowers U.S. corporate tax rates to 21% from 35% will give U.S. corporate profits a near term boost. How those extra earnings flow the economy remain to be seen. In theory, corporations can use their tax savings to hire more employees, pay higher wages, and reinvest in their businesses. Critics, on the other hand, suggest that the funds will likely be used to buy back stocks and increase dividends. As far as the market goes, a good portion of these benefits may already be priced into stock valuations given the recent run and high p/e ratios.
In addition, the Tax Act temporarily lowers personal tax rates for 2018 through the year 2025. As the chart below shows, most households will enjoy lower tax brackets. However, depending on their taxable income levels, some households may not end up paying less in taxes due to higher standard deduction levels as well as the elimination or curtailment of prior itemized deductions.
Please Don’t Flatten that Curve
In 2018, the Fed’s activities will be especially scrutinized. For starters, there is a new sheriff in town. Donald Trump decided to go a new direction when he did not nominate Janet Yellen to serve another term as the Fed Chair. Instead, Jerome Powell will begin serving his four year term on February 5th. Powell is a known quantity, given his experience as a member of the Federal Reserve’s Board of Governors where he’s served since 2012. Even so, it remains to be seen how he will shape the Fed and influence future monetary policy under his tutelage.
The Fed has a dual mandate of using its activities to target full employment and price stability (i.e. a 2% inflation rate). With the unemployment rate hovering at 4.1%, a level consistent with prior peaks cycle peaks, it’s hard to argue the Fed hasn’t at least achieved one of its goals.
The more perplexing issue for the Fed is the absence of rising inflation expectations and subdued longer term bond yields. Later stages of the business cycle are typically marked by rising asset values (which we have), lower employment levels (which we have), rising inflation (missing), and higher interest rates (Fed Funds rate has risen, but longer term rates have been falling, not rising).
Inflation has been stubbornly lower than the Fed’s 2% long term target. Of course, that might change as the labor force continues to tighten and the expansion rolls on.
Market watchers are growing concerned that the Fed will keep raising rates to the point that the yield curve completely flattens or inverts (a situation where short term interest rates are the same or higher than long term interest rates). Historically, a flat or inverted curve often precedes an economic contraction as banks struggle to lend money profitably and liquidity is drained from the system. Given that the Fed is keenly aware of the ill effects of an inverted curve, they will likely be reticent to raise the Fed Funds rate more than another 2 or 3 times to the 2%-2 1/4% (currently 1.5%) level, unless the 10-year Treasury bond rate moves up to the 2.75%-3% range from its current 2.4%.
The chart above shows the short end of the curve moving up over the last year with each .25% hike by the Fed while the long end of the curve has remained relatively constant. The difference between the yield on a 2-year Treasury bond and a 10-year bond stands at a mere .50%, not giving the Fed much room to raise without risking an inverted curve.
Global Equities – One Hit Wonder?
After several years of under-performance as compared to the S&P 500, non-U.S. developed and emerging markets woke from their slumber in 2017, outpacing even the surging U.S. market. The question is whether non U.S. equities were a one year story. Historically speaking, periods where non-U.S. equities outperform tend to go on for multiple year cycles rather than a one year episode.
Furthermore, there are several fundamental reasons why non U.S. markets may continue to outperform including rising profits, compelling relative valuations, and central bank stimulus programs that are still in place.
No 2018 market commentary would be complete without addressing the bitcoin phenomenon. Other than “I wish I owned some,” what can one say about something that has gone from $1,000 to almost $20,000 (now back to $14,000) in the course of a year?
In the next few years, it will become apparent as to whether Bitcoin, along with other digital cryptocurrencies, will earn its place in history as either one of the biggest bubbles of all time, or one of the most incredible emerging asset classes. What is clear, however, is that you will need ice in your veins to own some and hold onto it as the volatility inherent in cryptocurrencies is significant as compared to traditional stocks and bonds. In fact, it’s that volatility that will likely hold bitcoin back from becoming an acceptable mainstream method for making payments for good and services. Until it becomes stable, it will remain a speculative investment that relies on someone paying more than you just did in order to get a return. So far, investors have been handsomely rewarded for the risk they have taken.
Despite the real potential for a long overdue correction, it’s hard to bet that the S&P’s streak of 9 consecutive years of gains will come to an end in 2018. Outside of a market shock (i.e. an actual military confrontation in North Korea) corporate earnings growth should support stock prices, even if market sentiment slips and the market p/e contracts somewhat.
It is also likely that volatility will increase and that investors will have to endure at least some pain to get the gains in 2018. Risk management should prove to be more important going forward as a less accommodative Federal Reserve removes liquidity from the system. In addition, the tailwinds of increasing corporate earnings may be offset by the flow through effects of rising interest rates and higher costs of consumer debt.
Holding targeted positions in U.S., non-U.S. developed, and emerging markets should continue to work in this environment. In addition, should the U.S. dollar continue to weaken, investors will get a little added benefit from their diversification into unhedged non-U.S. equities. Despite low return potential, fixed income will continue to play an important stabilizing role in portfolios. Investors should utilize a blend of core investment grade bond positions along with smaller, less interest rate sensitive, positions.