Barron's Cover
Outlook 2018: The Bull Market’s Next Act
By Vito J. Racanelli
Wall Street’s eight-year love affair with stocks kicked into overdrive this year, spurred by a stronger economy, the likelihood of tax cuts, and a lack of compelling investment alternatives.
Donald Trump’s election as president in 2016 turned a bull with a midlife crisis into a high-powered charger, as investors cheered the Republicans’ pro-growth agenda and bid up anything that might benefit. Stocks have produced an 18% price gain, and a 21% total return year to date, as measured by the Standard & Poor’s 500 index, with low volatility and nary a trading session in which the popular benchmark closed down for the year. As for the market’s last big selloff—a 15% decline in February 2016—it seems a distant memory. On Friday, the S&P 500 index ended at 2651.50.
Given synchronized global growth and rising corporate profits, 2018 could be another good year for stocks, notwithstanding the bull’s advancing age. The S&P 500 could gain about 7%, mirroring similar gains in corporate profits, according to the consensus forecast of 10 investment strategists at major U.S. investment banks and money-management firms surveyed by Barron’s each December. The group’s predictions range from 2675 to 3100, with a mean estimate of about 2840.
The outlook isn’t entirely rosy: Interest rates are headed higher, stocks are expensive, and a tax overhaul could still stall or fail. But so long as corporate earnings keep climbing and the Federal Reserve raises rates in a measured way, the strategists see more room for gains.
“Rational exuberance is the stock market’s theme for 2018,” says David Kostin, Goldman Sachs’ chief U.S. equity strategist, harking back to the well-known but ill-timed “irrational exuberance” comment made by Federal Reserve Chairman Alan Greenspan in late 1996 about the rollicking bull market of that era. The market doubled after Greenspan’s veiled critique, only to lose about 50% from its top in the 2000 dot-com bust.
A rapidly expanding price/earnings ratio, or market multiple, drove the 1990s bull, but “it’s the earnings this time,” says Kostin, whose view is shared by his peers.
OUR PROGNOSTICATORS EXPECT S&P 500 earnings to climb to $145 in 2018 from an expected $131.45 this year. Most estimates assume that global growth will spur earnings gains, with an additional boost coming from U.S. tax cuts. Depending on the final tax bill, they figure that lower corporate taxes could be worth 5% to 10% of earnings growth, or anywhere from $7 to $14 a share. But in the unlikely event that no tax cuts are passed, the market could drop sharply.
Industry analysts forecast S&P earnings of $146.20 for next year, not including tax cuts. If analysts revise their estimates higher in coming months to account for the positive impact of lower taxes, stocks could get a further boost.
Market strategists are divided on whether stocks’ P/E ratios will expand. The S&P 500 trades for 18 times the next four quarters’ expected earnings, up from 17.1 times 12 months ago. While the most bullish forecasters look for P/E multiple expansion to help propel stock indexes, others worry that 2018 could be a “peak” year for P/Es.
The strategist got a few important things right last December in looking ahead to 2017. They predicted that stocks would rise this year, speculative activity would revive, and financial stocks would do well again after gaining 20% last year. Indeed, financials are up 20% this year. The strategists were too timid, however, in their market forecasts; their mean prediction put the S&P 500 at 2380 at the end of the year. That now seems highly unlikely, barring a sudden last-minute rout.
Financials, once again, are Wall Street’s favorite stocks for the new year. The industry should be helped by higher interest rates, lower taxes, and an economy growing by nearly 3% a year. The sector trades for about 15 times next year’s expected earnings, below the market multiple, and banks are some of the nation’s highest corporate tax payers.
Consumer staples, real estate, and utility stocks, on the other hand, are expected to underperform in 2018, due to rising interest rates. Because of their relatively lush dividend yields, all are considered bond proxies. The stocks are this year’s laggards: Utilities are up 14%; staples, 10%; and real estate investment trusts, 7%.
TECH STOCKS LED the market for most of this year with a gain of 35%, helped by an even more powerful rally in the so-called FANGs: Facebook (ticker: FB), Amazon.com (AMZN), Netflix (NFLX), and Google, owned by Alphabet (GOOGL). Market watchers now are neutral to positive on the foursome and the sector. At 17.7 times next year’s estimated earnings, tech valuations aren’t cheap, but they’re well below valuations in the dot-com era, and underlying earnings growth is strong.
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Investors worry that next year might see a move toward greater regulation of large tech names, which, some strategists fear, could play havoc with their shares and the market. Despite its Republican pedigree, the Trump administration seems unafraid to pursue antitrust actions against giant corporations, as AT&T (T) can attest; the Department of Justice has sued to block its $85 billion takeover of Time Warner (TWX). Social-media giants such as Facebook and Google have been caught in the crosshairs of congressional investigations into possible Russian involvement in last year’s election, while some critics decry the allegedly monopolistic tendencies of Amazon.
Led by Bitcoin, up 1,500% this year, to $15,232, cryptocurrencies are likely to stay in the spotlight in 2018, gaining even more investor attention. Some market strategists—and plenty of other people—worry that the virtual coins are merely a fad, however, whose trajectory will end in tears and rattle other assets, including stocks.
With interest rates still near historic lows almost a decade after the financial crisis of 2008-09, stocks have had plenty of runway for growth. Most strategists expect rates to rise in the next year, but not to levels that would imperil the bull. Our panel looks for the Federal Reserve to lift its federal-funds rate target on Wednesday by 0.25 of a percentage point, to a range of 1.25% to 1.5%, and follow up with three rate hikes next year that would take the federal-funds rate, on which other interest rates are based, to a range of 2% to 2.25%.
Jerome Powell, successor to Fed Chair Janet Yellen, is expected to continue her easy monetary policy, but could be inclined toward less regulation. That is another reason why financials are favored in 2018.
ED YARDENI, PRESIDENT of Yardeni Research, is no stranger to Wall Street but a newcomer to our panel—and its most exuberant bull. He sees the S&P 500 ending next year at 3100, which would reflect a gain of about 17% from current levels. Just don’t give all the credit to tax relief, he says; a second year of global economic growth could ignite fresh enthusiasm for stocks. Corporate earnings growth remains a relative novelty for investors. In the three years prior to 2017, S&P 500 profits were flat at about $118.
John Praveen, chief investment strategist at PGIM Global Partners, has a 2018 year-end target of 2925. His 2017 forecast was closest to the mark, at 2575. A longtime bull, Praveen cites falling cash levels at money-management firms as a sign that institutional investors are finally embracing the rally.
While the Street’s seers believe the market has already discounted about half of the expected tax relief, the tax bill, if passed, could be a gift that keeps on giving. Dubravko Lakos-Bujas, JPMorgan’s chief U.S. equity strategist, says the impact on corporate earnings “will resonate in the first and second quarters of 2018…and continue to be a positive tailwind [for stocks] into the first half of 2018.”
With the S&P trading well above its historical average of 15 times earnings, “it is accepted wisdom that the market is expensive,” says Stephen Auth, chief investment officer for equities at Federated Global Investment Management. But he argues that’s not the case, given the economic and interest-rate backdrop, a pro-business administration, and unattractive fixed-income alternatives.
Auth has a year-end target of 3000, derived by applying a P/E of 20 to his 2018 earnings estimate of $150. For all the talk of investor exuberance, he says, “we haven’t gotten to the point where taxi drivers are giving stock tips.” JPMorgan Chase (JPM) is one of his favorite stocks; the bank could earn $10 a share next year and deserves to trade at 15 times earnings, he says. That implies a stock price of $150, compared with Friday’s $106.
WHILE ALL OUR STRATEGISTS expect stocks to head higher in 2018, some see a yellow light, not a green one, suggesting that the bull’s days are numbered. Morgan Stanley’s chief U.S. equity strategist, Mike Wilson, anticipates a “below-average year,” with the S&P 500 up about 4%, to 2750, compared with a roughly 13% annual gain since 2012. Although earnings will rise next year, he says, this is a “late-cycle environment for the American economy and equity markets.”
The market’s price/earnings multiple could contract later in 2018 as earnings growth peaks and investors sniff out potentially lower growth in 2019, he adds.
Rob Sharps, chief investment officer of T. Rowe Price’s equity group, and another newcomer to our group, agrees. He expects market leadership to narrow in 2018, which is typical in the later stages of a bull market. Sharps calls the current environment “about as good as it gets” for financial assets, with investors buying every pullback. “You have elevated asset prices, high expectations, and aggressive positioning for ‘risk on,’ ” he says.
Unemployment has been around 4% for a while, he notes, adding that when the labor market is at full employment, the economic expansion typically is 60% to 65% complete. That suggests a recession could start in late 2019 or 2020, which investors would anticipate next year. Sharps likes Signature Bank (SBNY), a high-quality bank whose shares have dropped 16% from its peak, to $137, as the bank has had to pay more for deposits. He expects these headwinds to recede, and thinks the New York banking company could become an acquisition target.
Tobias Levkovich, chief U.S. equity strategy at Citigroup’s Citi Research, argues that investors shouldn’t look to tax cuts to keep the market roaring. They are a “one-shot deal” in boosting year-to-year earnings comparisons, and might not even be permanent. “The Street doesn’t believe that the Democrats could take the House of Representatives in 2018, but they could,” he says.
Levkovich, one of the least bullish strategists, has a year-end 2018 target of 2675 for the S&P 500. Should investors accord the same multiple to tax earnings as to operating profits? “I don’t think so,” he says.
Moreover, any gain from a tax cut could be diluted in part through research, development, and capital spending, says Savita Subramanian, head of equity and quantitative strategy at Bank of America Merrill Lynch. It isn’t clear how much corporations will get to keep and return to shareholders directly, she says. The strategist, who has a 2018 year-end target of 2800, sees positive sentiment and momentum driving stocks higher in what she calls a potential “year of euphoria.” She favors the materials sector, noting it tends to perform well in the later stages of a bull market, and likes DowDuPont (DWDP), the global chemical company.
SOME INVESTORS EXPECT a reduced tax on companies’ overseas earnings to produce a cash windfall at home. But Goldman’s Kostin warns that might not be the case. He estimates that U.S. companies have $2.5 trillion in untaxed earnings overseas, of which $922 billion is in cash. About 85% of that cash belongs to only 20 companies, chiefly in the tech and health-care sectors. Kostin, with a 2018 S&P target of 2850, favors the industrials sector, which will benefit from solid capital-spending trends and global growth. Deere (DE), in particular, is investing for growth, he notes.
While Federated’s Auth expects the FANGs to take a breather, especially with stronger growth in gross domestic product and lower taxes lifting other boats, he considers the stocks to be big growth compounders longer term. He looks for Facebook and Alphabet to get an additional lift from higher profits by the middle of 2018.
For another view, there’s JPMorgan’s Lakos-Bujas. He downgraded tech to Underweight last Monday; the sector is flat since then. He bases his negative assessment primarily on “tactical” factors—namely, a conviction that value stocks are set to outperform growth stocks, the bucket in which tech stocks fall.
The spread between value and growth has reached a point historically associated with a reversal; the Russell 1000 value index is up 9% this year, against a gain of 27% in the comparable growth index. Tax reform is a catalyst for a rotation into value stocks, as value companies generate almost 80% of their revenue in the U.S. and are subject to an effective tax rate of 30.3%, the strategist observes.
Market strategists expect U.S. stocks to outperform bonds again in 2018, especially with interest rates rising. The Bloomberg Barclays U.S. Aggregate Bond index is up only 3% this year, and 10-year Treasury yields have fallen to 2.38% from 2.45%, although they have rebounded from a low of 2.04% earlier in the year. (Bond prices move inversely to yields.) The strategists’ 2018 year-end consensus forecast for the 10-year Treasury yield is 2.8%. “It’s hard to like bonds,” says Yardeni, summing up the prevailing view.
Merrill’s Subramanian worries that yield-hungry institutional investors are “aggressively positioned and over-own” REITs and utilities, which yield more than government bonds. Compounding the problem, utilities tend to carry high debt loads, she notes. “They look like a bond, trade like a bond—and bonds aren’t where you want to be,” she says.
Globally, most market watchers say U.S. stocks are the place to be in 2018 because of earnings expectations. But fans of overseas markets note that many are earlier in the earnings-recovery cycle. Jeffrey Knight, co-head of global asset allocation at Columbia Threadneedle Investments, notes that U.S. equities rank poorly on various valuation metrics when compared with international stocks, which suggests that the rest of the world will catch up. That said, European, Asian, and emerging market stocks are outperforming the U.S. in dollar terms this year. The Stoxx Europe 600 index has returned 23%; Japan’s Nikkei average, also 23%; and the MSCI Emerging Markets index, 31%.
Knight, who has an S&P forecast of 2750, favors equity markets in developing economies, Australia, Hong Kong, and Japan.
IF MUCH IS LINED UP to go right in 2018, a few things could go spectacularly wrong. A recurrence of inflation is one thing many market watchers fear. While it has been quiescent for years—the consumer price index hasn’t met the Fed’s 2% target—stronger economic growth could ignite it. If core inflation, excluding food and energy prices, were to top 3%, it would be a problem for markets, says Federated’s Auth.
The strategists all fear that the Fed could raise interest rates too aggressively, which would take away the market’s punch bowl. There could also be a negative impact on the consumer and the economy. “I worry about the cumulative impact of rising rates on Americans,” says Citi’s Levkovich. “There are people who have financed their lives on low rates for nearly a decade.”
A regulatory attack against social-media companies, or even the hint of one, could also hit the market hard. Earlier this year, as T. Rowe Price’s Sharps notes, the president tweeted negative comments about Amazon, and executives from Facebook and Google were called before Congress to testify about how foreign nationals might have used the social-media platforms to interfere in U.S. elections. A negative policy response to the sector “could knock the legs out of the U.S. market and the rest of the world,” Sharps says.
Then there’s the parabolic rise of Bitcoin and cryptocurrencies generally—and concerns that a fear of missing out also could lead investors to chase stocks with similar desperation. Alternately, a Bitcoin crash could curdle investor enthusiasm for all risk assets.
But investors aren’t worried yet.
So long as earnings are rising, rates are low, volatility is subdued, and every stock selloff is met with more buying, as happened again this past week, the bull will still rule over Wall Street.
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