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4 Themes in 2018 Thumbnail

4 Themes in 2018

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Kevin Michels, CFP®, EA

2017 proved to be a great year for not only the U.S. stock markets, but international markets as well.  The S&P 500 Index, which represents the 500 largest publicly traded companies in the United States was up 22% in 2017, while developed international markets rose 27% and emerging international markets rose 37%.

A lot went right for the stock markets in 2017, namely the anticipation and fulfillment of tax reform, as well as deregulation here in the United States and overseas which all led to higher corporate earnings, steady job growth, low unemployment, and slightly higher wages.

Many of the factors that contributed to the outstanding growth in 2017 will most definitely carry over in 2018.  However, 2018 will face some unique challenges of its own in the form of not-so-friendly monetary policy and a much longer-than-average bull market.

As we enter the ninth year of the current bull market and economic expansion, here are 4 important themes to keep an eye on in 2018:

Rising Interest Rates

Since dropping the Federal Funds rate to 0% in 2008, the Federal Reserve had only felt confident enough to raise rates by a quarter of point 3 times before 2017, in December of 2008, 2015, and 2016.  In 2017 alone we saw three additional increases of a quarter point, in March, June, and December.  The Fed feels confident enough now to raise interest rates slowly but steadily and we could see 2-4 more increases in 2018. 

Low interest rates have fueled a lot of the growth over the past decade as corporations have been able to expand due to the low cost of obtaining capital through financing.  In addition, due to the low yields bonds have offered over the past decade, many investors have shifted funds from bonds to stocks which has driven prices upwards.

Even with the rate hikes in 2017 and the expected hikes in 2018, interest rates are still historically low, which as stated before, greatly benefits companies trying to grow.  However, with interest rates rising and getting closer to normal levels, we could see more conservative investors shift their money back to bonds offering more attractive yields.

Withdrawal of Quantitative Easing (QE)

During the financial crisis of 2008, as part of the Federal Reserve’s strategy to stimulate the economy, they began to inject money into the economy by printing new money and buying government bonds, a policy known as Quantitative Easing (QE). 

As the economy slowly recovered, the Federal Reserve began withdrawing from QE.  In 2014, they began to taper money printing and government bond purchases down to zero.  Last year, they actually began “deleting” some of the printed money from the financial system as well. 

One of the biggest benefits we saw from Quantitative Easing was a much less volatile stock market.  QE injects more money into financial markets and takes an equal amount of safe government bonds off the market.  The combination of more money being created, and that money being invested in the stock market, instead of government bonds, has led to a very steady growth in stock prices.  As QE draws to a close, the stock market will most likely return to its normal level of volatility which means more frequent 10% to 15% market corrections, which is common and healthy market behavior.

Tax Reform & Strong Corporate Earnings

Anticipation of tax reform, and more specifically lower corporate tax rates, was one of the factors that fueled positive investor sentiment throughout 2017.  Late December, the Tax Cuts and Jobs Act was passed and the corporate tax rate was reduced to 20%.

The most obvious effect a lower tax rate will have on corporations is higher earnings.  Higher earnings mean increased wages and more money to expand which all have positive effects on the economy and the stock market.  We’ve already seen that happen as companies like Delta and Visa have announced higher bonuses for lower-level employees and increased company matching in 401(k) plans.

Longer-Than-Average Bull Market

Since 1970 the average bull market has lasted about 4 years and 8 months posting an average total gain of 165%.  The longest bull market lasted 12 and a half years between 1987 and 2000 posting a 582% gain. 

We’re approaching the 9th year of the current bull market, well past the average but still 3 years short of what we experienced from 1987-2000.  The S&P 500 has seen a total gain of over 300% since the bull market started in March of 2009, once again, well-above the average but still well short of the 582% gain from 1987-2000.

No doubt this run could continue as the stock market will benefit from stronger corporate earnings and deregulation domestically as well as internationally.  However, it will be facing a strong headwind in the form of tighter monetary policy (rising interest rates and withdrawal of QE), which leads us to believe that while 2018 should be a positive year for the stock market, we’re not expecting 20%+ returns like we had in 2017.

The Bottom Line

2018 will be an interesting year as we see how all these themes play out.  We always make it a point to stress that we don’t know where the market is headed over the next month, year, or few years, especially since there is no way of accurately and timely predicting black swan events such as 9/11 or the bursting of the real estate bubble.

However, with the market constantly reaching new highs David and I often get asked “how much longer will this continue?”.  Because we do not have a crystal ball, and do not pretend to, we always refer back to our client’s financial plan to answer that question.

The important question isn’t, “how much longer will this bull market continue?”, more so “when will I begin to draw down my investment accounts, and at what rate?”

In other words, if your financial plan tells us that the first distribution from your assets will occur 15 years from now, without certain knowledge of the market highs and lows over the next 15 years, we would recommend that you keep the course appropriate for your risk tolerance and time horizon.  Which in this case, would most likely be a recommendation of continuing to invest the majority of your accounts in stock, despite the record market highs we’ve been experiencing.

As we get closer to that distribution time, we would certainly make adjustments to compensate for the volatility and unpredictability of the market.

On the other hand, if your financial plan is telling us that you’ll begin distributions in 5 years, then we would definitely want to take a look at your asset allocation and ensure you are positioned correctly to withstand the negative effects of a large market correction or bear market without adjusting your retirement goals if possible.

In the end, it’s never about market highs, market lows, or market-timing.  The key to investing successfully is taking away the emotion and biases, and basing your investment decisions on your risk tolerance, risk capacity, and time horizon.