The St. Nicholas Viewpoint: 2018 Market Outlook
by Tim Cebulko CFA/CFP, President, Chief Investment Strategist January 18, 2018
It’s very difficult to believe that the turmoil that was 2017 translated into annual stock market returns approaching 20%. It’s even more difficult to believe that the Federal Reserve invoked three interest rate increases throughout the year, yet bonds still had positive total returns in the 2%-4% range. These two observations are perfect examples of why market pundits and fund managers should refrain from market forecasting. The reality of the 2017 situation was that almost no predictions at the beginning of the year matched results at the end of the year. St. Nicholas was no different. As is typical for us, we refrained from any specific predictions last year, admitting only that we were “cautiously optimistic” on stocks and that bond returns were likely to be “flat to slightly negative”.
Fortunately for our clients, we have always taken a long-term view of investing and year-to-year market predictions have had little to do with our long-term approach. Basically, we look to make good long-term investments and take what the market gives us over the short term. This means we will hold both bonds and stocks in down markets…so don’t expect much in the way of short-term market-timing-based re-allocations. Over time we’ll obviously see down markets in both asset classes, but we’ll also eventually emerge from them with sound investments that we’ve deemed fit to stand the test of shorter-term volatility. This approach is not new for us, and history has proven that it’s the most effective strategy in the long run. None of this is to say we are predicting negative markets – we really aren’t predicting anything at all. This discussion is simply a re-education in discipline and patience. Good investments reward over time, and patient investors, through up and down markets, can reap above-average returns if they have disciplined and successful managers like St. Nicholas.
Fourth Quarter Performance Review
It was nearly impossible to find losing markets in the final quarter of 2017. Both domestic and international markets experienced extremely strong results for the final three months of the year. Domestically, stocks rallied mainly as a result of improving investor sentiment related mostly to the potentially positive influences of tax reform. International markets also improved significantly due mainly to continued growth abroad, but also gained influence from US markets and the temporary fade of the bellicose badgering surrounding North Korea. Accepting that fourth quarter returns were fantastic across the board, we’ll cite only annual returns in our observations here. International markets finished 2017 with higher returns than most domestic indices, so we’ll start there. The best performing major index last year was Emerging Markets with the MSCI EM index up 37%. Not far behind was China’s Hang Seng at 36%, with developed international (MSCI EAFE) finishing the year up 25%. Here in the US, the NASDAQ led the way up 28% and the cyclically-laden DJIA was equal to the task, up 28% as well. Much farther behind but carrying more reasonable overall valuations was the S&P 500, increasing just over 19%. Mentioned earlier, bond total returns remained positive for the year, settling in the 2%-4% range, depending on average maturity.
Now before everyone starts asking why we didn’t own international or emerging markets after such big years, we will remind them that we also did not own them for the past ten years when both indexes averaged less than 2% annually. We will also remind clients that while we haven’t had much direct international exposure, most of our companies have international operations that continue to grow and contribute to returns. There may come a time when we look for more direct international exposure through one of the sector ETFs, but we haven’t gone that direction in quite a long time. Regardless, St. Nicholas clients did quite well on their own in 2017. Our account composite was up about 18.5% for the year, bringing annual returns very close to the S&P 500 price change. We continue to see spectacular long-term comparisons, with most of our clients seeing long-term numbers that are two to three times greater than the S&P 500. If you’re a client who hasn’t been here long enough to see such magnificent comps, our only advice is to be patient – our discipline has worked extremely well over the long run and we see nothing in the way of preventing that from continuing in the future.
A Quick Word on Bitcoin
We are starting to get an increasing number of inquiries regarding our views on Bitcoin. Admittedly, many of these inquiries are not coming from clients, but from friends, neighbors, and relatives. We have very quickly developed an “elevator story” on the subject and our general observation is as follows: Bitcoin is a currency – a crypto currency yes, but a currency nonetheless – and we simply have never nor will ever deal in currency trading on behalf of our clients. It’s difficult to define any currency investment as long-term and we simply have no interest in serving as a short-term trader for clients. It’s simply not what we do.
Another underlying reason for avoiding Bitcoin is that we simply just don’t have a thorough understanding of the product. We’ve read multiple definitions and explanations, and it just doesn’t make enough sense to us to even pretend that we understand it or the blockchain technology that it was originally intended to facilitate. What we do indeed understand, however, is that Bitcoin holds no true inherent value, it is unregulated (many investment houses and exchanges worldwide have already forbade trading in Bitcoin), it’s price is being manipulated largely by naive individual investors who very likely have even less understanding of currencies than we do, and it is extremely speculative. Like many speculative bubbles that have existed in the past, we don’t deny that money can be made, but we’re not stupid enough to believe that huge sums can’t be lost in mere minutes as well. Our biggest fear is that Bitcoin and/or the crypto currency market in general could eventually grow into a speculative excess that has the ability to cause collateral damage to global financial markets. Fortunately for now crypto currency exposure as a whole is extremely limited, but we know that can change rather quickly. Still, our advice is a very stern “Stay away…stay very far away!”
As predicted, after giving Fed Chair Janet Yellen his full endorsement, President Trump wasted little time in dismissing her at the first opportunity. Ms. Yellen did not get re-appointed to a second Fed term, the first such Fed Chair non-reappointment in more than 40 years. She was instead replaced by current Fed Board of Governors member, Jerome Powell. Although obviously qualified for the position, Mr. Powell is a rare selection given that his background is in law whereas almost all of his predecessors were economists. Regardless, we are relieved that he has Fed experience and has participated in the formulation of Fed policy over the past five years. Accordingly, there was little market reaction to the announcement of his appointment and consensus opinion is for a smooth transition that entails a continuance of the gentle-but-disciplined rate-raising strategy.
In atypical fashion, the Fed was kind enough to not only provide a rate-increase schedule for 2017, but follow it to a tee. The Fed kept markets well-informed of their rate plans throughout the year and held to an oft-predicted three rate increases for 2017. There is no such direction for 2018 thus far, but surveys of current Fed members at the December meeting resulted in a predicted range of two to four rate increases for 2018. It’s very likely that markets have already discounted the next two to three rate hikes, so don’t expect any material market reaction unless or until we get to the fourth increase or if the Fed’s rhetoric changes due to altered economic observations.
The median economic growth forecast offered by the Fed is for 2.5% growth in 2018. This may prove to be conservative as we may be looking at three percent or higher growth for the past three quarters. While we state frequently that the US economy is like a very large ship – hard to slow and even harder to reverse – the real unknown for 2018 is the impact that tax reform will have on overall growth. The massive US economic ship is already steaming ahead at a steady pace and the extra juice of tax reform may provide the tailwind that pushes growth above fed forecasts or targets. This may mean a future possibility of more frequent rate hikes of greater-than-expected magnitude. We are not predicting an unexpected economic boom, but we want clients to be aware that the possibility exists. The implications of unexpected growth should be good for stocks in the near term, and conversely worse for bonds. However, too-rapid or higher than expected growth has other implications and we are much more comfortable with steady growth that is more easily controlled by Fed monetary policy.
The Equity Markets
In our last letter we ridiculed the media for exaggerating the significance of Dow 23,000. For the moment, our point was right on given that we are already hovering around Dow 26,000. While we are not saying we won’t see Dow 23,000 again (we very likely will at some point), we re-emphasize our caution regarding sensationalism in the media. Their focus right now appears to be on speed. For every one thousand points since Dow 20,000, you are certain to find headlines exaggerating how fast the latest 1,000 points accumulated. While we agree that the stock market indices have accelerated at an above-average pace, simple math tells us that it should take less time for each level of 1,000 points the higher the market goes. The higher the market level, the faster we should get to the next 1,000. At some point the media will move on to another focus, but in the meantime, don’t get overly concerned with these shorter treks.
Without being overzealous ourselves, we will concede that the equity markets have indeed continued to move along at a rapid pace. While a twenty percent return year is always nice, it does extend the long leg up into yet another year, with markets not experiencing a material yearly decline since 2009. Not surprisingly, the best performing sector last year was technology and we continue to expect tech to lead as long as the market moves upward. The industries to avoid last year were telecom and energy, both declining by mid-single digits. The best-performing S&P 500 stock was Align Technology – the makers of Invisalign, the dental braces alternative – increasing over 135%. Noteworthy as well, the worst-performing stock in the S&P 500 was Frontier Communications, down 86% for the year. For various valuation and earnings reasons, we owned neither, but we always appreciate an interesting stat.
So what does the future hold for stocks? Based on the first two weeks of trading, 2018 looks to be another fantastic year, but be careful extrapolating from such a short window. As has been proven historically, a short time frame is a poor guideline for a market that is influenced by many factors. We’ve only seen 4% of the year so far, and it is a guarantee that markets won’t continue to increase at the same pace for the remaining 96% of the year. As a matter of fact, expect the exact opposite and you’ll do fine. Last year produced less volatility than we have seen in more than half a century. Remember 2009-2012 when we each year we experienced intraday moves of 10% as many as five to ten times a year? Intraday! For a while there we were seeing such moves almost once a week. Well, 2017 saw nothing close to that, experiencing just 1% fluctuations at its most volatile, and that happened only eight days the entire year.
We were spoiled last year and we warn clients to get ready…volatility will definitely return and it may return in violent fashion at times. We still think we can get positive equity returns this year, just don’t set the bar too high and get ready for a bumpier ride. Be prepared for shock-tempting headlines of thousand-point drops in the DJIA, but also remember that 1,000 points is now less than a four percent move, and a four percent drop should certainly be in the realm of expectations. The longer the expansion gets, the more that patience will be needed. We like the look of the economic landscape, and that should prove to be the ultimate driver of stock prices. Earnings will continue to increase, but the real question is for how long. Let’s just hope that growth is strong enough and steady enough to induce equity investors to continue to buy the underlying stocks.
An annual return of 2% would not typically invoke a “wow” reaction, but it certainly does for us. Actually, a two percent return should never get a “wow” from anyone no matter the source, but we can’t seem to go any other direction. We are admittedly in awe of where bonds ended up for 2017 and our opening paragraphs already touched on this. If anyone would have told us that the Fed would hike rates three times in addition to announcing a doubling of their balance-sheet-shrinking program, we would have likely changed our outlook from “flat to negative” to just simply admitting that positive returns would be out of the question.
Again, not letting predictions override strategy, we maintained our bond discipline on behalf of all of our clients – stay short and maintain good credit quality. The end result was that most of our fixed income clients did a bit better than the benchmarks, albeit it with absolute returns that were some of the lowest we’ve seen in several years. Still, we own bonds for many reasons and total return is only one of those. Bonds are typically part of an overall approach. Not only do they produce steady and necessary income streams, but they do so with much less volatility than most asset classes. They also present higher long term return potential than other shorter-term asset classes including money markets and cash. Still, economic and market outlooks can certainly influence components of our approach, so we need to share our expectations for 2018 and beyond.
In spite of the lack of a specific schedule, count on the Fed making another two or three rate hikes this year. Regardless of the continually improving job picture, we aren’t looking for the wage-push inflation that typically accompanies end-of-cycle economic strength. This means that inflation will not likely reach Fed targets, and the Fed may look to slow the rate increase schedule. We know money will continue to become inherently more expensive as the Fed dumps more bonds into the open market, but the effect here may also make rate increases less desirable. Given these circumstances, we still don’t expect a harsh reaction from the bond market and will throw out another “flat-to-negative” bond return prediction for 2018. Strategically this means much of the same approach – keep maturities short and credit quality high, leaving us flexibility to improve yields as they continue to creep higher.
By all accounts, 2018 returns should be an easy forecast. We have a pretty good sense of the known factors that drive prices. Interest rates will remain low on an absolute basis and we should expect just two or three normal rate hikes this year, meaning bond returns should be flat to slightly negative for the year. Inflation is subdued and will likely remain below the Fed’s long term target of two percent. GDP growth should land somewhere around 3.0% – 3.5%, and average earnings growth estimates (already adjusted for tax reform effects) should be up 10% – 11% over 2017 levels. All considered, these factors should produce positive equity returns once more, perhaps somewhere in the low double digits.
The question then is whether or not this will all come together and form another near-perfect year. The answer, unfortunately, is that it likely will not. Earnings growth and stock returns do not share a direct relationship, and quite often there is a disconnect. There are many factors that affect stock prices and earnings are just one. Investor sentiment must remain high, and that will be difficult in a very precarious geopolitical environment. There will be other unknown influences like weather, earthquakes, tsunamis, hurricanes, and various other “storms of the century”. Terrorist attacks will remain a huge threat, and we have no idea of the next big war and/or act of aggression. Bottom line, we like the look of the economy and remain optimistic but tread cautiously with a market and economy that are growing very long in tooth. Cautiously optimistic on stocks and bonds at flat-to-negative…sound familiar? Cross your fingers and remain patient through the anticipated increased volatility…2018 will certainly be interesting but will hopefully be rewarding as well.
 Based on a composite of fully-discretionary equity-only portfolios representative of our primary equity management style. This composite only includes stock portfolios that have been managed solely by Tim Cebulko since inception. Composite returns are not independently audited but have been verified internally and are believed to be reasonably accurate representations of actual account returns. Composite returns are gross of management fees and are dollar-weighted. Past performance is not intended to be a guarantee of future results.