2017 left investors with a huge challenge as we all move into 2018.
After a 21.6% return on the Standard & Poor’s 500 stocks in 2017, do we let the money ride for 2018 or move it into other assets? Some stocks had almost unbelievable years in 2017. Amazon (AMZN) was up 56% for the year an Facebook (FB) climbed 53%. But those gains were left in the dust by the 96% gain on Alibaba (BABA) and the 115% racked up by Tencent Holdings (TCEHY). And even stocks seem to be standing still in comparison to biotech such as Madrigal Pharmaceuticals (MDGL), up 510% in 2017 or Sangamo Therapeutics (SGMO) ahead by 466%.
For 2018 should you leave your money in those big winners from last year? Take some of it off the table and put it into laggards? Move some of it to cash?
I raised those questions in my performance update for my long-term 50 Stocks Portfolio, which returned 28% in 2018. I didn’t provide much in the way of an answer in that post. Or even give you guidelines for how to think about answering those questions. Let’s see if I can do a little better in this post for that decision on the 50 Stocks Portfolio and on the other portfolios where I will be reporting performance over the next week or so.
Here’s my thinking on the challenges facing your portfolio decisions in 2018. There are four big ones.
The U.S. market is trading at all time highs and valuations are stretched or at least full. This doesn’t spell doom in and of itself. A market can go higher from record highs if there’s money on the sidelines that can come in to generate new buying. One problem is that allocations to U.S. stocks seem to be near all time highs too. For example, the TD Ameritrade investor movement index, which tracks allocations among retail investors to equities, reached an all-time high of 8.59 in December. That follows on an all-time high of 8.53 in November. Retail investors at TD Ameritrade have now been net buyers of stocks for eleven consecutive months. That’s not the longest buying streak in the indexes history but it is among the longest. Professional money managers don’t show quite the same record allocation to stocks and out of cash. The Bank of America Merrill Lynch survey of money managers showed cash positions in their portfolios rising to 4.7% in mid-December from 4.4% in November. That put an add of a string of months that saw cash positions fall.
At the same time a 4.7% cash position in December isn’t especially high by historical standards and a record 48% of managers believed the U.S. market was overvalued in November–only, of course, to see stocks rally in the last half of December and into January. These cash positions show why January is such a critical month for this market. Cash flows into the hands of money managers and passive investment vehicles are strong at year end so that cash positions should climb in December and January. The question then is how much money will go into the stock market from those new cash flows and how much remain on the sidelines.
The Federal Reserve is likely to raise interest rates at least two times in 2018, possibly three times, and even, unlikely, though it might be four times. Rising interest rates don’t make bonds an attractive alternative to stocks. In this same Bank of America survey 83% of money managers believe bond markets are overvalued, up from 81% in November and close to the high of 85% in October. At this point the market seems to be torn between a belief that economic growth and wage inflation will be mild enough to keep the Fed to a schedule of two interest rate increases in 2018. That’s still not wildly positive for bonds. And as much as investors and money managers may worry about valuations in the stock market, they are perfectly capable of noticing that the 22% return for the S&P 500 in 2017 was significantly above there 2.80% return from holding 10-year Treasury notes.
One danger to the financial markets is that traders and investors are too complacent about the Fed’s schedule for raising interest rates, but we won’t know–and I don’t expect that markets to anticipate–if the Fed will be more aggressive until after we’re seen an actual increase at the Fed’s March and June meetings. If those meetings produce interest rate increases, then I think the stock market will start to fret about a third increase–and maybe a fourth–in 2018. The other danger is that the Federal Reserve might actually be, as some members of the Fed worry, behind the curve on inflation.
In 2017 inflation stubbornly refused to close the gap between actual inflation and the 2% inflation targets set by the U.S. central bank. Right now the Fed seems to be pooh-poohing the possibility that the Republican tax cuts might add too much stimulus to an economy showing a few signs of heating up (in the low 4.1% unemployment rate, for example.) Again, I don’t think we’ll see actual evidence of rising inflation before the second half of the year–if then.
I’m starting to hear the odd question or two about how long this economic upturn can last. For example, David Von Drehle, a columnist for the Washington Post, recently raised the prospects of a “Trump recession in 2019 or 2020. His fears belong to the “if something can’t go up forever, it won’t” school (the quote is from Herbert Stein, the head of the Council of Economic Advisors until Nixon and Ford.) The current economic expansion, although not especially strong, began in June 2009 and is not the third longest on record.
The tax cut, Von Drehle argues (and I’d agree) makes it likely that the economy will have enough juice to break in April the streak of 107 months without a recession set by the U.S. economy in the 1960s. That will leave the current economy behind only only the 120-month run of the 1990s. This economy with its tepid wage growth and its below trend recovery from the bottom in 2008-2009 certainly doesn’t seem like the one that belongs at the top of the heap. The 1990s streak, for example, had Internet technologies as a driving force. But the problem with a belief that everything ultimately regresses to the mean–or suffers a recession–is that it doesn’t tell you when the regression/recession starts.
The effects of the tax cut on corporate profits and the growth in the global economy argue for this economic expansion to last for a while yet–through 2018, it’s likely. Possible factors that could derail the recovery include an increase in oil prices (the result of war in the Middle East), or an outbreak of race to the bottom trade restrictions. Those are more likely to be factors in the second half of 2018 than in the first six months of the year.
And finally there’s the question of expectations. Especially of earnings expectations. The stock market, I’d remind you in great big type, is an anticipatory machine. The current explosive rally in 2018 is on anticipation of a big increase in corporate earnings breaking out in the first, second, third quarters, and fourth quarters of 2018. In 2017 Wall Street projects that full year earnings growth was something like 10%. For 2018 Wall Street is officially expecting 12%–but that figure doesn’t fully include the effects of the recent cut in the corporate tax rate. Once that lower tax bill starts showing up in earnings reports, I think forecasts for growth will move higher. And on a belief that the regulation-cutting agenda of the Trump administration is about to reduce costs in sector after sector (energy and banking look like big winners) and let loose animal spirits in the executive suits that will lead to a big increase in capital investment. Those expectations should lead to higher asset prices in 2018 (all else being equal) because companies will show earrings growth on those trend due to the increase from the baseline in 2017. And in 2019? Well, the baseline for expectations won’t be 2017 any longer, but 2018. And looking forward companies won’t be receiving another cut in 2018 or 2019.
The biggest cuts in regulation are likely to have been attempted–and in 2019 companies are likely to have already seen the biggest net change (or the defeat of changes in court.) All this means that at some point in 2018 Wall Street and its analysts will start looking ahead to slower earnings growth (not lower earnings, mind, but a reduction in the rate of growth) as the big initiatives of the end of 2017 and early 2018 start to show up further and further back in the rearview mirror. When do I expect that shift in point of view? Wall Street tends to work in six-month horizons so I’d expect that somewhere around the middle of 2018 investors can expect to start seeing forecasts that focus on slowing growth in earnings in 2019. (And, of course, by that point we’ll be right on top of what promises to be a very volatile mid-term election and the economic recovery will be even longer in the tooth.
Put all this together and what are the implications for anyone looking to rebalance a portfolio?
That the first half of 2018 will look a lot like 2017 and that you don’t need to undertake major rebalancing.
Minor tweaks that are likely to be worth while are moving some money into inflation hedges (gold and commodities) and shifting some money out of U.S. stocks and into what are currently perceived as slightly less over-valued overseas developed and emerging markets.
And that the second half of 2018 could–and I’d stress “could”–look very different from either 2017 or the first half of 2018. May or June would therefore be an appropriate time to do a second rebalancing that takes account of what we know about trends that are, at the moment, uncertain or emerging.
I’ll put these implications to work in rebalancing my portfolios as part of my beginning of 2018 performance review. The Perfect 5 Active Passive ETF portfolio will get the most obvious changes–although they won’t be all that major for the first half of 2018–and in the next few days. That ETF portfolio is available to subscribers to my Juggling.com and JubakAM.com subscription sites.