2018 Stock Market Outlook

It's January again, and that mean's another year of trading opens in 2018 closing out the 52 weeks assigned the 2017 label. A new year brings new investment opportunities and closes out others. Rallies and rotations look to be extended, but traders know anything can happen. In 2016, for example, the stocks welcomed investors into the new year with a 220 point drop in the S&P 500 before rebounding over 400 points to end the year in a rally. The rally continued, and 2017 did not disappoint.

From Yahoo Finance

Like a smooth ramp, the top 500 companies in the United States (the S&P 500) grew steadily this year breaking record after record. Only a few red days in April threatened to slow the rally, but those were easily trumped by the green days the followed. The S&P 500 returned 19 percent, the Dow Jones Industrial Average returned 25 percent, the NASDAQ returned 28 percent, and the passive investor once again grinned cheekily. The astonishing bullish sentiment has active investors scrambling to not be left behind, and ETF investing on the rise. In 2017, ETF inflows totaled $475 billion breaking the 2016 record of $287.5 billion. ETF assets are now worth $3.4 trillion with most of that capital landing in U.S. equity funds.

From Multipl.com

2017 was no doubt a good year, but as mentioned above, it's a new year of trading, and the only way to look is forward. Where else to start but earnings. The well-known Shiller PE Ratio currently sits a 26.2x. The valuation metric continues to grow as price rallies continue to overwhelm earnings growth. With the Trump administration one year old, traders still speculate that EPS numbers will catch up to the prices they at which they trade. The passing of the tax bill has brought abounding optimism in the words "corporate tax cut" that certainly helps Wall Street (Main Street standby). Despite varying opinions on the legislature, a weak general consensus sees a higher national debt and slightly higher gross domestic product. However, the economic jury still deliberates and trades on these hopes could be labeled as speculation.

From Conference Board
The Conference Board provides a nifty little view of the picture that economic data paints of the economy. Based on the historical chart, the indicator has proven itself to be pretty timely in its movements. The last six recessions were preceded by a drop in the Leading Economic Index. Entering 2018, the indicator is back on the rise after what looked like a threat of flattening. The strongest numbers that supported it in November were: the ISM New Order Index, Leading Credit Index, 10-year federal funds rate spread, and consumer expectations for business conditions. In summary, businesses and consumers are continually feeling more optimistic about the economy with new orders growing and expectations improving. Additionally, rising interest rates are supporting the financial services industry and helping margins recover after the long period of flat rates.

NYSE New Highs - NYSE New Lows from Stockcharts.com
With the exception of high valuations, most measures of stock market sentiment are pointing towards optimism. However, that optimism is as frail as its ever been. Both political and financial pitfalls threaten to send the market into turmoil. Essentially, in 2018 there's more downside than upside. Over the past five years, stocks have consistently been posting record numbers with widespread new lows rare. However during periods of shakiness in the market, the number of new lows skyrocketed over a few trading days. And so, fragility remains, and there are a handful of things that look like they could end the nine-year run of the bulls:

  • Nothing says stock market crash like "thermonuclear war," and scary enough, those words aren't too far from the lips of the most talked about (and arguably the most talkative) leaders, Donald Trump and Kim Jong-Un. While realistically, "thermonuclear war" is an extremely unlikely outcome of the conversation between the leaders of North Korea and the United States, the build-up and excessive deterrence can have a negative impact on the stock market in the way of volatility. In 2017, these moments were not absent and have shown investors that even something as simple as a nuclear missile test can cause a red day.
  • Again, political risks arise as a reason the U.S. stock market could crash, but instead of foreign political risks like the previous point, domestic political risks are the reason here. President Trump shocked the system with his surprise election in 2016 and looks to continue to push his agenda going into 2018 after a radical attempt to repeal the Affordable Care Act and the passing of Republican-supported tax reform. Investors have put a lot of money on the pro-business tactics of the Trump administration spurring on the "Trump rally." To extend those gains, Trump must follow through on his antics as well as successfully renegotiate dozens of trade deals he finds unfit. But with Democrats winning some key elections in 2017, the domestic political pendulum could swing heavily to the left side.
  • Another danger that could cause the stock market to crash is a major slowdown in an emerging economy like China or Brazil. As projected, emerging economies have become a huge source of global growth and enormous demanders of commodities and industrial goods. PIMCO saw a small recovery in Brazilian and Russian GDP in 2018, but a large part of those forecasts are based on the improvement in commodity prices. Weakness in agricultural commodities can pose problems to Brazil's economy, and a tumble in energy commodities could threaten Russia's economy. Additionally, PIMCO says that China's economy is not expected to "disrupt" the global economy, but the Chinese credit expansion over the past couple of years still leaves some risks to consider. Like seen in late 2015 and early 2016 with China, weakness in a major emerging market can create shocks.
  • The Federal Reserve and interest rates continue to be in focus as 2018 rolls around. Not only do investors have to consider where the Federal Funds rate might be by December 2018, but they must also consider what the new Fed chair Jerome Powell could bring to the table. CPI Inflation rates have recovered from only 0.1 percent in 2015 but still haven't reached the 2 percent inflation target. Currently, the Federal Reserve sees a median of 3 rate hikes in 2018 which is justifiable considering the optimism in economic numbers. However, with the amount of debt in the economy, any unfavorable policies or adverse reactions to policy plans could cause emotions to take over.
So in 2018, expect to walk a path similar to the one in 2017. The Trump trade continues to roll stocks higher as earnings slowly trudge behind prices. The fragility of the situation is not to be underestimated as shares reach all-time highs and buying opportunities appear less and less. Nevertheless, a smooth 2018 should coax stocks even higher with technology leading the way (once again).

2018 S&P 500 Performance: 15%
2018 Dow Jones Industrial Average Performance: 17%
2018 Nasdaq Performance: 20%


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