2018 1st Quarter Outlook

Review of 2017

It was a great year for investing. The best since … well, let’s wait until the second paragraph to provide historical perspective. First the facts. U.S. stocks rose by 22%, international stocks increased by 25%, and emerging markets stocks rose by 36%. Even bonds increased in value by 4%. Not only was the performance of stock and bond markets strong, but there was hardly any volatility. Indeed, each quarter the bond market went up by between 0.5% and 1%. And then shortly after the end of the year, the Dow Jones Industrial Average crossed the 25,000 milestone. There was much rejoicing.

Now for some perspective. While the financial press seems to be regarding last year as unprecedented, we’ll point out that U.S. stocks had their best year since … 2013, when they rose by 32%. Indeed, 2017 was only the third best year in the past 10 years. Our memory often plays tricks on us, and we believe that recent good times are truly unique. While we’re thrilled that investors, specifically our clients, enjoyed good returns, last year was solid, but not unparalleled.

We’ll also point out that we made the case for a strong market continually in this blog, beginning in November of 2016. Our analysis throughout the past 14 months has been that 1) the economy was strong, with steady GDP, low unemployment, and very low interest rates and inflation, and 2) earnings growth over the next couple of years was likely to be spectacular, according to security analysts’ estimates. The projected earnings growth did materialize, so it’s not surprising that the prices of stocks grew along with those earnings.

State of U.S. Economy Below is a table showing key economic and market indicators (as of December 31) 1 :

The data continue to show the strength in the economy. The main concern outlined by the above table is the priceearnings ratio, which has been rising and is above its historical average.

Stock Market

The main question is how long will market values continue to rise. First, let’s eliminate a myth. We read many articles that suggest the market has continued to increase in value for the past nine years without any correction in values. That’s simply wrong. As recently as two years ago (between December 1, 2015, and February 11, 2016), stocks declined by 13%. Earlier in 2015, stocks declined by 10%. So that’s two market corrections (defined by a drop in prices by at least 10%) in the past three years.

Our outlook on stocks hasn’t changed. We believe the market will continue to retain its strong valuation for as long as earnings grow at an abnormally high rate. Between 2010 and 2016, corporate earnings grew at a modest 4% per year. In 2017, earnings growth was 21%. Earnings are forecasted to grow over the next two years at 19% and 10%, respectively, per analysts’ estimates. With such growth in earnings forecasted over the near future, and low interest rates and inflation projected to continue, it’s not a surprise to see an above average price earnings ratio.

There’s a lot of discussion in the press about how long a market cycle can last. Much as we love analogies, the market and the underlying economy are not biological organisms with some predictable life span or cyclicality. It’s important to consider that this nine-year run up in stock prices started as a recovery of the worst recession, and as a result, the worst stock market, in over 70 years. We consider the first few years as simply a give back of the negative returns generated between in late 2008 and early 2009. After that recovery, both the economy and corporate profits enjoyed slow and steady growth for several years, which led to a solid but not always spectacular stock market. 2017 appears to be the start of at least a three-year period of growth in company profits, which explains the good stock returns of last year and why we don’t believe the market is overvalued today.

Bond Market Outlook

For investors, the best type of bond market is a boring bond market. Yields have crept up over the past two years, mainly because of the actions by the Fed to increase rates. Since the Fed’s actions have been slow, steady, and predictable, the increase in yields have come without much negative reaction in bond prices. The Fed has announced their plans for continuing the policy of two or three small rate increases per year, so we would expect a similarly steady bond market in 2018.

Summary

Despite the positive indicators we’ve referenced throughout this outlook, there are identifiable risks to investing in stocks. The main risk is because of the high price earnings ratio, if earnings growth over the next couple of years is less than what’s been forecasted, stock prices will likely decline. However, we also must point out that over the past decade, the biggest market declines have been caused by factors that weren’t identifiable – whether it was waning Chinese economic growth, falling energy prices, or defaulting mortgages. While we remain optimistic, prudence is always an important factor in considering your allocation to stocks and bonds.

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