2 down, 10 to go: 2018 Outlook

Until mid-February, U.S. Equities had the strongest start to a year since 1987, mostly catalyzed by tax reform and a seemingly endless inflow from investors who are scared to miss out on an ongoing bull market.  With valuations and debt at all-time highs, three more rate hikes on the horizon, and increased volatility, could February’s negative return for the S&P be the first sign of the recession that many anticipate? Not necessarily:

Discussion of a recession dominated headlines in early February when fears of inflation, investor profit-taking, and an increasing 10-yr dealt the DOW a serious blow. The index lost nearly 2,200 points from high to low over 4 trading sessions. This loss was likely exacerbated by arithmetic trading that exercised sell orders given short term market movements. Unsurprisingly, the VIX spiked to its highest levels since 2015 (the product UVXY that I wrote about popped 160% on the action). But there’s a difference between a “healthy” 5-10% correction, and a significant market pullback. Here’s why I don’t see the big hit coming in 2018, and view last month’s pullback as an opportunity to buy the dip:

There are undoubtedly drawbacks to the new tax bill, as it added one-time costs to many earnings reports in 1Q18, but its lower effective tax rate should have materially positive effects on equities throughout 2018.  Some companies will return cash to their employees, others boast replenished R&D budgets for the next several years, and a few more pledge dividend increases & share buyback programs to benefit their stockholders (Tim Cook is the latest executive to make such an announcement). It is true that the tax bill will affect various industries to significantly different degrees, but generally, bottom lines will increase with lower tax rates. In turn, EPS expectations move higher and when multiplied by the PE, share prices rise. In his annual letter, Warren Buffett revealed that Berkshire Hathaway profited $65 billion in 2017, $29 billion of which was a direct result of the tax bill passed in December.

Further, macroeconomic conditions remain strong. Unemployment holds steady at 4.1%, and wages continue to grow, albeit not fast enough. Consumer spending remains strong, and the rate at which Americans save is at all-time lows (which is unsustainable long term, but is a favorable short term indicator for consumer demand).

Potential headwinds that could cause increased volatility and smaller pullbacks nonetheless in 2018:

Interestingly, the 10-year T rate has moved well above 2.8%, and reached as high as 2.95% on February 21st.  If this return works its way up to 3% and higher, perhaps investors will begin to take their gains in stocks and phase into fixed income for security in their portfolios. Investors continue to pour money into equities because other asset classes haven’t offered attractive enough returns, and equities boast strong fundamentals considering solid earnings growth (especially with buybacks and dividend increases). As fixed income offers higher returns while the FED raises rates, investors may react accordingly. A transition from equities to fixed income would cause a pullback in stocks, the degree to which is hard to estimate. Specifically, a selloff due to algorithmic trading could loom if the 10-year hits 3%. While hard to anticipate the degree of its effect, traders undoubtedly have sell orders on their stocks at a barrier of 3% with the 10-yr.

Another macro headwind, and perhaps the most impactful, is the continual shrinking of the FED’s balance sheet. Raising rates, while healthy for the economy in the long term, scares investors temporarily as they believe higher rates stymie business growth through more expensive lending. It will be crucial to monitor the FED’s activity here; broadly, Powell is expected to maintain Yellen’s approach to the reversal of quantitative easing. This could cause pullbacks, but again, unlikely to massacre stocks as it is generally anticipated and is largely priced in.

There is a study that analyzes the performance of the markets over the course of a Republican and Democratic presidency which I have mentioned in previous posts. In summary, the market outperforms the first two years under a Republican president, and underperforms the final two years, and vice versa for Democrats. This implies that the markets have high expectations for the markets the first two years that a Republican is in office, only to have such expectations let down in the final two years. Will the Trump administration follow this trend? Will expectation continue to build markets up, and will we see a drastic pullback in 2019-2020?

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