I believe 2018 should be an interesting year for both the financial markets and the world economies. Spotting the end of the bull market is difficult, and assuming I could tell you exactly when the stock market was headed for a decline, I doubt many would believe me. However, I do think this historical bull run will continue a while longer. But first, a history lesson.
I remember working in my office in October 2008, watching the S&P 500 close lower and lower for 10 straight days. It was like a scene from the 1993 Bill Murray movie Groundhog Day: every day thinking the market had to bounce back, only to find out the trading pattern had stayed the same. After that grueling period where the S&P 500 dropped 25 percent, I asked myself: Why? Why did this happen so quickly, and why wasn’t anyone buying stocks? As someone who loves to follow stocks and the market, I had to find out the answer.
The market reacted this way because an entire sector (the financial sector) of the market vanished, namely bank stocks. Those stocks contributed almost 40 percent of the S&P 500 earnings. In rough numbers, the total S&P 500 earnings were estimated at approximately $90 going into late 2008. Once the market realized that an entire sector would generate zero earnings as banks were failing (Bear Stearns, Washington Mutual, and Merrill Lynch all were forced to merge with larger banks), the new estimate for S&P earnings was just $55. In essence, the market had to reflect this decline in earnings and the decline in earnings from other sectors of the market due to the recession.
While these were troubling times for the market and for those who worked in finance, I knew that things would get better. Lo and behold, on March 9, 2009, the S&P hit a low for the bear market cycle and essentially hasn’t looked back. We are now in one of the longest bull market cycles of our lifetime.
So where does valuation put this bull market, and what is next for stocks? I think this market can move higher, but the gains will be harder to come by as valuations are starting to get stretched. The forward PE as shown in JP Morgan’s Guide to the Markets slide for September 2017 is 17.7 times. Also, in the Dec. 9 issue of Barron’s, there were several estimates on S&P earnings for 2018.
In fact, the article stated that S&P earnings have totaled plus or minus $117 for the last three years, but 2018 estimates are as high as $141, and could be 7 to 10 percent higher with the new tax bill. If we use a $155 number, stocks don’t look as overvalued. The real proof is in the pudding. Will the tax bill have the positive impact we are all expecting? The stock market currently thinks so.
Where the math gets fuzzy for me is if interest rates move up quickly right when the global equity markets begin to experience their first signs of a Central Bank quantitative-easing hangover. The Fed raised short-term rates in December and is expected to raise rates two or three times in 2018. If we don’t see a corresponding move higher in long-term rates from economic expansion, a few more short-term rate hikes, and we may see an inverted yield curve. Historically, this is a death knell for the economy, almost always leading to recession six to nine months after the inversion. We will save that analysis and discussion for another article.
It is safe to say we are cautiously optimistic on the financial markets in 2018 and think the math works for the markets as long as tax reform has the desired outcome and central banks don’t overstep. We are recommending our clients maintain their target allocations with an emphasis on international equities, the alternative asset class, and short-duration fixed income. And for those who can’t stomach the higher level of risk, cash is an asset class that gives the option to buy in the future at potentially lower prices.
Randy Williams-Gurian is a wealth manager at HighTower Bellevue. He authors his own national newsletter and offers his insights on tech stocks and other investing how-to tips on CNBC and elsewhere.