New market thoughts from Raymond James’ Andrew Adams: “Charts of the Week” 01/03/18

Investment Strategy: “Charts of the Week”
Andrew Adams | (727) 567 4807
Summary
A new year has arrived and with it a sense of new beginnings, great potential, and a clean slate. It is the time for resolutions and resetting expectations, yet, as we all cast our gaze forward to what 2018 will bring, it is also the time for a wave of “market outlooks” to be unleashed upon investors. Now, I know what readers probably want – a succinct guide for the coming year complete with predictions, target prices, and a ready-made portfolio to beat the market – but, as we have written before, it’s hard enough to anticipate where the ever-shifting global market machine will be 12 days from now, let alone 12 months! Just think back to where we were at this time last year. If there was one thing that every strategist and pundit knew was going to happen in 2017 it was that we were in for a wild, volatile ride with the “unpredictable” Donald Trump moving into the White House. So, naturally, what happened? Why, of course, we got the lowest volatility year on record by several measures and the S&P 500 never fell more than 3% at any point. Try predicting that! We certainly didn’t, even as optimistic as we were about the secular bull market.
Consistent with this view, instead of trying to make a bunch of dart throws for what stocks will do in 2018, we think a better exercise is to analyze the current conditions to identify the dominant trends in place, and then adjust accordingly throughout the year as those trends change. And many of the trends will certainly change, which is why we write these market commentaries every day instead of just once per year. Proceeding this way helps avoid becoming married to a prediction despite possible evidence to the contrary, as well as making confirmation bias less likely, where you only seek out information that supports your prediction. We think this approach is even more important this year given the implementation of the new tax laws, which stand to have a major impact on what happens to the U.S. economy and corporate earnings going forward. The big question in 2018 will likely be whether the tax cuts will encourage businesses to invest in their capital and workers, thereby stimulating economic growth and prolonging the expansion that has been in place since the Great Recession. Expect to see a lot of focus and speculation on how the tax changes are trickling down into the economic data.
With that said, while we have no idea where the S&P 500 or any other market will finish at the end of this year, we do enter 2018 once again optimistic and not really seeing the red flags that would cause us to worry about the health of the secular bull market. The kind of year we experienced in 2017 just doesn’t happen if the underlying foundation is unsettled or crumbling, and while there were laggards, the majority of the U.S. stock market performed well and participated in the general uptrend. Most of the major averages remain at or near their all-time highs, as well, and the sectors leading the market are the ones we want to see leading. The bulls appear to have history on their side, too, considering that the year following the 32 other 20% total return years in the S&P 500 since 1928 saw an average gain of 10.46% (median 12.80%), with only one finishing with a loss of more than 10% (1937; source: Bespoke Investment Group). Moreover, we have compared our current market to the mid-1990s for the last two years, and the closest comparison to 2017 from a drawdown perspective actually ended up being 1995, with ~3% max losses in the S&P 500 during both years. That seems to be good news since 1996 turned out to be a pretty good year, with about a 20% total return and only an 8% max drawdown.
Therefore, we don’t recommend changing a whole lot in your portfolio if you’re already set up for the secular bull market. If the uptrend does, indeed, continue as we expect, the more cyclical sectors that we have liked and written about should continue to do well, even if there aren’t many attractive low-risk entry points that we’re seeing at this exact moment. The odds do favor seeing increased volatility this year compared to last, though of course, it won’t take much in terms of price swings to make that statement true given the extremely calm market of 2017. As a result, the key to performance in 2018 may be to not panic when volatility does pick up at some point. The fear is that investors have become too complacent and will then be shocked into selling once the market starts going down in earnest for the first time since early 2016, but as long as the weight of evidence continues to support the secular bull market, we think any dips will still be for buying.
There are risks, of course, but that never ceases to be the case. We have argued repeatedly that valuations aren’t as stretched as many believe for various reasons, but they are still comparatively high, which does allow for less margin for error should conditions start to turn and may motivate investors to sell out more quickly than they otherwise would. Corporate earnings and most economic indicators will also have a higher bar to overcome this year than last, though the hope is that the tax cuts and synchronized global growth will continue to push these measures of health above their year-over-year comparisons. Consequently, the bottom line is that stocks appear to be set up nicely for more gains in 2018 but we do still recommend remaining flexible and tuned in just in case that outlook changes. We also continue to prefer a more active approach given the low correlations across the stock market and high valuations. This does seem to remain a stock picker’s market.
Finally, remember that the markets may seem to change from year to year but the rules don’t: 1) Take smart bets; and 2) Cut the ones that don’t work before the losses become too severe. Investing becomes a lot easier if you follow those two rules, but, of course, consistently following those rules is where the real challenge lies.
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