Prognostications Roundup

With the new year in full swing it's the season when market analysts of all shapes and sizes reveal their educated guesses about what the markets and economy are likely to do in the year ahead. While many of these prognostications aren't worth the time it takes to read them, some come from very good analysts and are worthy of our attention.

There are several common themes for 2018 as I review reports from three groups I pay close attention to, Bespoke Investment Group, Vanguard's Investment Strategy Group, and Dr. David Kelly at JPMorgan. While none of these analysts would say they're predicting the future, they would likely all say how important it is to be aware of these key themes and how markets might react to them. So, let's look at my summary of their recent work.

Economic Growth, Unemployment, and Wages
Final GDP numbers for 2017 won't come in for a while yet, but assumptions are that the final number will around 3%. If so, this level of growth would be higher than the past few years but still stubbornly below the longer-term average of 3.25%. The expectation is for a growth boost in 2018 fueled by business investment and tax policy, followed perhaps by a tapering off into 2019.

This tapering, should it occur, is expected to be blamed on an increasingly tight labor market. As 2017 ended our main unemployment rate stood at 4.1%, a level most economists would agree is considered "full employment". Strangely, this metric is expected to fall further as businesses expand hiring, perhaps aided by new tax breaks, and hire the few remaining workers out there. But then they hit a brick wall unless a bunch of folks who are currently out of the labor market decide to jump back in. One of the potential outcomes of this would be a long-awaited boost to wages and ultimately a spike in inflation.

Interest Rates and the Bond Market
Assuming the economy continues to expand and if wages should increase at a faster pace, the Fed would likely feel forced to raise rates faster than the bond market is thinking. Currently, the bond market is pricing in about two interest rate increases in 2018 while the Fed itself has signaled three. Analysts are starting to feel like four increases might become necessary. Should this be the case, it would likely cause ripples in the bond market as prices fall to adjust to higher rates. This is one of the reasons we've kept our bond duration (exposure to rising rates) low.

The Dollar
The dollar declined by about 10% in 2017 and could fall further this year. Such moves benefit many foreign markets and US companies with heavy foreign operations, and could act as a continued tailwind for stock prices in such sectors as Technology, Healthcare, and Materials. But these currency moves can change rapidly, so it's best not to get too carried away with chasing sectors to play a falling dollar.

Investors Turning More Bullish
Members of The American Association of Individual Investors (not the only group of its kind, but perhaps the most prominent) have finally turned bullish on stocks after reporting many, many months of bearish sentiment. Often thought of as a contrarian indicator, individual investors might say they're more bullish, but they still have largely not put their so-called "dumb money" where their mouth is. New money flows into stock mutual funds and ETFs were weak in 2017, with individual investors opting for bonds. So, a good indicator to watch will be whether these flows shift to start favoring stocks over bonds. This too could be a tailwind for stocks, at least for a while.

Valuations
Stock valuations are a function of how much investors are willing to pay for a dollar of a company's earnings. If investors are growing more bullish they might be willing to pay more than is reasonable, or even way more, and the question becomes how much is too much. As we begin 2018, many stock analysts are increasing their earnings projections for companies, in large part due to the themes previously referenced, but also due to expectations about how the new tax overhaul will benefit corporate bottom lines. As these expectations increase, stock valuations decrease, making for a suddenly slightly less expensive market. This can fuel the market's continued rise, but only if analyst expectations are accurate, a question only answered over time.

So far, the new year is picking up right where the old year left off with solid stock market gains, low volatility, and tepid performance from high quality bonds. None of the major indicators are flashing "recession" and several are instead indicating continued growth. One of the general concepts permeating the analysis I read is optimism, tempered by the reality that we're in the later stages of the economic cycle and expansions don't last forever. When will it end? That's anyone's guess, but it's not likely to end real soon.
Here's a quote from Bespoke that sums it up nicely...

Bull markets don't die of old age, and they don't die because of valuations. Their demise is usually the result of a downturn in the economy or a major shock to the system. On the former, we don't yet see that in the cards, and the latter is something no one can predict. Unless things change or the internals start to deteriorate, the bull should live on. Simple as that.

Even so, let's be disciplined and vigilant nonetheless.

Have questions? Ask me. I can help.