It’s that time of the year when we tentatively try and predict which way Mr. Market will go next year. And hope we don’t end up being embarrassingly wrong. So my cunning plan is to faithfully follow the dictum of John Maynard Keynes to “….be roughly right than precisely wrong.”
But first the Big Picture. 2018 is a critical year, as central banks will provide less support via monetary policy. Hence markets will depend far more on business fundamentals, fiscal policy and economic growth. Which is a perfectly normal development- the multi trillion dollar quantitative easing of the past 8 years wasn’t.
I think this bull market has legs, at least in the short term. So why the optimism? Big hint: lot of it revolves around tax cuts.
# 1 Sharing is caring
The drop in tax rates will blow open a USD 1.5 trillion gap in the budget over a decade, a gap that future generations will have to fund. It will also lead to greater inequality as the rich get taxed less compared to the great unwashed. From a long term perspective, money is better spent on education and infrastructure than tax reform. Plus companies ain’t gonna spend all that tax windfall on capex and jobs.
But who cares about long term effects and loyal workers, especially when you can reward….. drum rolls please….. fickle and greedy shareholders! So the tax reform is great for shareholders as companies will launch even greater stock buy backs and share prices should rise as a result.
# 2 Spend like there is no tomorrow
Back to tax reform- this will put billions in the hands of not just corporations and but also Joe and Jane and may spur consumer spending, something that has picked up recently. Economists fondly recall such positive effects the last time taxes were cut, in the era of the Gipper in 1986.
# 3 Boom time for Earnings
The S&P 500 is expected to expand profits by 13% in 2018, according to estimates compiled by Bloomberg. One reason is the drop in tax rates.
Barclays estimates that tax cuts will increase 2018 earnings per share by an average of 6.3 %, with the increases ranging from 1 per cent for the real estate sector to 11.9 % for the consumer staples sector. It’s possible that these effect of tax cuts hasn't been fully priced in. As such, since the legislation passed, multiple firms have boosted their 2018 year-end price targets
All these may help earnings catch up somewhat with current nose bleed valuations but don’t bet on “reasonable” P E ratios for a while, especially in growth stocks.
# 4 Banking on rising rates
The Fed may gradually increase rates in 2018. This is good news for banks as long as there is a spread between short and long term rates. Why? Because banks borrow short term (lower rates) and lend long term (higher rates) and that’s how they make their money... So some bank stocks look interesting.
# 5 Buying on the dip
Stock market corrections don't worry investors any more these days. They "buy on the the dip," which is basically buying more whenever prices drop. Even the briefest market decline triggers this behavior. Why? Probably because since 2013, central banks have communicated that they may step in to protect markets, leaving investors confident enough to buy on the dip
# 6 No sharks in the water
There are zero systemic risks on the horizon today. Yes yield curves have been flattening but that’s due to low inflation expectations, asset managers buying long duration bonds, increased issuance of shorter term bonds and rising short-term rates in anticipation of Fed moves. There is no bad news in today’s flat curve; it’s an INVERSION of the curve that you should worry about.
A credit market sell-off, a NAFTA collapse etc. could trigger a collapse. But context also matters; solid growth and low financial sector leverage now act as barriers to contagion. Geopolitical risk is quite high- North Korea, Iran etc.- but such risks usually cause only short-lived sell-offs, provided the economic backdrop is steady ( which it is).
What do I predict for the S & P? Nothing specific- predicting such numbers is a mug’s game. I mean look at all the big boys. In 2016 they predicted that the S & P would rise an average of 5.5% in 2017!! The reality? As of today the S & P as gained 20%. This time Goldman, UBS, RBC et al are all predicting between 2,800 and 3,000 for year end 2018.
Note- Strategists have underestimated this bull market from the start. And bull markets tend to end with this group overly bullish, not bearish!
2017 was the Year of the Rooster. 2018 is the Year of the Dog. Let’s hope it isn’t a dog year for US stocks.
PS- There are too many Ifs, Buts and Maybe's to list here.
PPS- Terms and conditions apply. Caveat Emptor. Etc etc.