A Surprisingly Strong 2017 Makes Way For A Promising 2018

The S&P 500 finished 2017 by completing an unusual feat. Not only was the index up +22% (total return), but every single month of the year saw positive performance on a total return basis, and in fact, the index is on a 14-month winning streak (Note: the previous record of 15 straight was set back in 1959!). So, as you might expect, volatility was historically low all year, with the VIX displaying an average daily closing value of 11 (versus a “fear threshold” of 15 and a “panic threshold” of 20). But some of 2017’s strength was due to expansion in valuation multiples in anticipation of tax reform and lower effective tax rates boosting existing earnings, not to mention incentives for repatriating overseas cash balances, expansion, and capex.

Sector correlations also remained low all year, while performance dispersion remained high, both of which are indications of a healthy market, as investors focus on fundamentals and pick their spots for investing – rather than just trade risk-on/risk-off based on the daily news headlines and focus on a narrow group of mega-cap technology firms (like 2015), or stay defensive (like 1H2016). And Sabrient’s fundamentals-based portfolios have thrived in this environment.

Now that the biggest tax overhaul in over 30 years is a reality, investors may do some waiting-and-watching regarding business behavior under the new rules and the impact on earnings, and there may be some normalization in valuation multiples. In other words, we may not see 20% gains in the S&P 500 during 2018, but I still expect a solidly positive year, albeit with some elevated volatility.

Market Commentary:

It was an unusually eventful year when you consider all the turmoil surrounding President Donald Trump’s first year in office and divisive political rhetoric hitting a fever pitch, as well as synchronized global economic recovery, the biggest tax overhaul in over 30 years, historically low interest rates (including negative rates overseas), appointment of a new Federal Reserve chair (who is dovish like the outgoing chair), the marked rebound in oil and commodities, the bitcoin rocket ship (ultimately spilling into other cryptocurrencies), historically massive wildfires, floods, and hurricanes, North Korea missile launches and nuclear threats, national anthem protests against social injustice, eons of workplace sexual harassment finally confronted, the concert massacre in Las Vegas, a rare total solar eclipse, and incredible sports comebacks (including a Super Bowl having a record-breaking comeback and first-ever overtime). Also noteworthy this year, in April Sabrient began publishing a new Baker’s Dozen top picks list every month, rather than just twice a year – all of which have performed well in a climate in which fundamentals matter to investors.

US stocks were buoyed all year by strong global economic reports, rising corporate earnings, domestic deregulation, and massive global QE generating demand for the relative safety of US assets, resulting in a persistent uptrend with no significant corrections. The S&P 500 closed the year at 2673, so the 3000 mark is a mere 12% higher, which I think is achievable. I also think stocks may finally endure the significant correction that was so elusive last year, but it would mark a healthy cleansing that ultimately leads to higher prices for the next few years – barring any major disruptions from the myriad geopolitical risks, not the least of which is the global credit bubble and the need for careful deleveraging, especially in China (as it also navigates through a fundamental transition from disinflationary state-owned manufacturing to inflationary consumption and spending among its burgeoning middle class).

Looking at ETFs representing various market segments, the S&P 500 (SPY) was up only +0.7% in December, but some segments did much better. Standouts during the month included Oil & Gas Equipment (XES), Steel (SLX), Transportation (IYT), and Retail (XRT). For the full-year, the SPY finished +22%, the Dow (DIA) +28%, Nasdaq 100 (QQQ) +32%, Nasdaq Composite (ONEQ) +29%, S&P Mid Cap 400 (MDY) +16%, Russell 2000 Small Caps (IWM) +13%, and S&P Small Cap 600 (SLY) +13%.

The year was characterized by strong performance in the Momentum factor at the expense of Value, Quality, and Low-Volatility factors, although Value and Quality kept pace or outperformed after the market’s slight dip in August, when investors noticeably started focusing more on fundamentals. While the SPY was up +22% for full-year 2017, S&P 500 Growth (SPYG) was +28% versus S&P 500 Value (SPYV) +15%. Looking at the sectors within the S&P 500, Information Technology was by far the top performer for 2017 at +40%, followed by Materials, Consumer Discretionary, Financial, and Healthcare, which were all around +22-23%, and then Industrials at +20%. Energy and Telecom were the only sectors to be in the red for the year, although Energy had a nice resurgence late in the year.

Oil closed the year right at $60, and its strength has provided a welcome boost to the US and Canada. Commodities are suddenly perking up, as well, as they are historically cheap relative to stocks. Jeffrey Gunlach of DoubleLine Capital observed, “…the value in commodities is, historically, exactly where you want it to be a buy.”

Emerging markets have benefited, too, including Brazil and Russia, both of which had been languishing in deep recession. India also has been quite strong. Looking at other developed markets, Japan has benefited from new fiscal stimulus added to continued monetary stimulus, while the Eurozone has been boosted by its own continued monetary stimulus coupled with improving domestic demand.

As for China, rather than continuing to grow through manufacturing and exports (and a large current account surplus) by leveraging low labor costs, state-run enterprises, and state support of private business, which is disinflationary, the country’s leadership has been trying to boost domestic consumer consumption and spending (reducing its current account surplus), which is inflationary, while simultaneously deleveraging its dangerous credit bubble. Nevertheless, the World Bank has bumped up its expected 2017 GDP to +6.8% and forecasts only a modest slowdown to +6.4% in 2018 and +6.3% in 2019. My hope is that China can indeed engineer its way through this fundamental transition and deleveraging process without a major disruption to the global economy.

In the US, The BEA’s final estimate of real GDP in Q3 came in at 3.2%, and for Q4, the Atlanta Fed’s GDPNow model is now forecasting 2.8% (as of December 19, down from 3.3% on December 19, but an update is coming on January 3), while the New York Fed’s Nowcast model projects 3.9% (as of December 29). Corporate Profits surged to a new high of an annualized $1.854 trillion, putting the year-over-year change at +10%. Housing has been particularly strong, with some calling it the biggest story of 2017. Investor Sentiment, Consumer Sentiment, and Consumer Confidence (a 17-year high in November!) all remain strong. New Jobless Claims remain near the lows of the economic expansion, so despite hearing a constant storyline about the labor market under attack by robots, AI, and productivity-improving technologies, hiring has still managed to achieve a post-recession high.