2018 Outlook: Still riding the secular bull

12-01-2017

Readers of this space know we have been talking about a prolonged, secular bull market since 2010. Along the way, various S&P 500 intermediate milestone targets we set have been passed, even if at the time they seemed a bit far-fetched: 1,400 for year-end 2011 (achieved in March 2012), 1,660 for 2013 (May 2013), 2,500 sometime between December 2017 and June 2018 (achieved September of this year). Our most recent target, 3,000, was set in June 2017 with a goal of sometime in 2019. In reviewing our outlook for next year, the macro team has subsequently accelerated our timing for this goal to December 2018.

We won’t reiterate all the key drivers of what we expect to be a generational move up in equities without a bear market as we define it (a decline in stocks by 30% or more within a 12-month period). We’ve had two such bulls since the 1930s (1950 to 1971 and 1974 to 1999). Note that both of these secular bulls, which took markets higher by a factor of 10, did experience occasional corrections of 10% and even a few of 20%, washing out the weak hands and creating the base for the next advance. We believe we are in an advance of this magnitude that could last many more years. So if we do get a correction along the way, hold the course and use it to add to stocks. In secular bulls, you buy corrections, you don’t sell rallies.

So, despite the terrific run we’ve had in stocks this year and the ever-present temptation to declare victory and sell, we advise patience. Although we would not be surprised to see some kind of mild correction late this year or early next, we are not forecasting one and are not playing for one. Rather, we are recommending staying the course at a significant equity overweight, and expect solid gains out of this secular bull through next year. As of this writing, S&P 3,000 is still a good 14% or so away.

Four drivers to watch
When we last added to our recommended equity overweight in September, we cited four drivers that we thought could take markets higher by year-end. As we review those four drivers today, we see them all continuing to be in play for 2018, supporting our continued bullish stance: 

  • Earnings Interestingly, as we moved through the Q3 earnings season, the consensus numbers for next year moved up, not down like they were “supposed to.” Bottom-up consensus is now $147 for the S&P next year, and that probably doesn’t have the full impact of the corporate tax cut in it. At Federated, we are at $150 for 2018 and think $160 is not out of reach for 2019. Ultimately, when you buy a stock, you buy a company with an earnings and cash flow stream that is growing and likely to pay you back more than you paid in. This fundamental positive support for the market is very much in place today, particularly after the 18-month earnings recession we experienced in 2015 and the first half of 2016. I underscore this point for a key reason: while the consensus call on the market for most of this year has been “valuations are expensive,” that call has been based—erroneously in our view—on trailing earnings that included the 2015-16 earnings recession, during which 2016 earnings were $118, making the market at 2,500 seem expensive at a 21 P/E. But our focus always has been on 2018, looking ahead, not behind. Even at current levels, the market based on our expectations is trading at about a 17.5 multiple—not dirt cheap, but not expensive, either, especially for a market with so many other positives going for it.
  • Economy Again, the numbers on the economy keep getting better. The bears were focusing most of this year on the difference between the good “soft numbers” and the no-so-good “hard numbers,” but now even the hard numbers are coming in stronger. Q3 GDP was just revised up this week, giving us two straight quarters of 3% real growth. We expect another 3% GDP print in the current quarter as the economy continues to steam forward, bolstered by make-up spending from storm-driven September weakness. Three 3% quarters in a row under a pro-growth, pro-business, anti-regulation president is too many to ignore. At a forecast 3%, Federated is above consensus again for 2018 GDP as we see continued momentum in the months ahead from the underappreciated, fast-acting regulatory relief, increased business and consumer confidence, rising global demand and … tax reform (reform, not just cuts).
  • Tax reform Most strategists we’ve been speaking to have been in the “this won’t happen” and/or “if it happens, it will be watered down” camps. They are now eating crow. It is happening, and the 20% corporate rate that is in both versions of the bill is way below where even we expected it to be. We are all used to looking at tax reform with a Keynesian perspective, and so everyone is running around calculating how little spending stimulus will come from this bill. We agree. What they are missing is the longer-term investment stimulus that the lower corporate rate/higher after-tax returns on capital is likely to have next year and beyond. We think this tax package is the biggest thing to come along for the U.S. economy since the Reagan tax reform in 1986. P.S., by potentially improving economic productivity through higher capital spending, this tax reform can improve growth without necessarily raising inflationary pressures.
  • The Fed The central bank may be the biggest risk. If the Fed gets nervous due to “late cycle” stimulus/inflationary fears, and accelerates hikes on the short end, the yield curve will continue to flatten or even invert, and a recession could be upon us. We don’t see this happening. We think inflation pressures will continue to be light due to a variety of causes that we think are behind “the long cycle:” the global marketplace for labor, the large pool of underemployed workers still in the U.S. and more so in Europe, the deflationary forces coming from the new economy players (think Amazon, Uber, etc.), and the robot age that is finally upon us (If the marginal worker is a robot, or an iPad taking food orders at LaGuardia, what is “full employment?”). We may soon be able to add to this list the tax reform bill, which by encouraging corporate investment should raise productivity and lower the so-called Phillips curve—the theoretical inverse relationship between inflation and unemployment that says the former tends to rise when the latter falls to near historical cycle lows—that has everyone so worried. President Trump looked for and got a Fed chair who subscribed to his line of thinking, which we see as follows: slow down on interest rate hikes now that we’ve got fed funds rate to near “normal,” shrink the QE-bloated balance sheet as the primary form of tightening, and back off bank regulations that have stifled lending and the money multiplier. We expect one or two hikes next year, after the December hike that is coming, and probably slightly faster quantitative tapering (QT) than the path laid out by Yellen, along with less regulatory pressure. We think this backdrop is very market supportive, especially for the Financials sector. 

Sectors and industries we like in this environment include banks, energy, biotech and high free-cash-flow tech. These sectors benefit most from the above four forces. But what makes this a bull market is that it is difficult to find sectors that don’t benefit from at least some of the above. 

So, the bull rides on, and as usual, the bears are fueling the rise as they scramble to cover their shorts and get invested. Tighten your saddles and enjoy the ride.