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Investment Strategy

Prophecy is Full of Risks

The new year presents each of us with a clean slate—an opportunity to hit the reset button and start anew. We make our resolutions, and maybe a few of us create new habits that will make us healthier, wealthier, and wiser going forward. It also presents chief investment officers with the dubious honor of making predictions about the upcoming 12-month period.

The new year presents each of us with a clean slate—an opportunity to hit the reset button and start anew. We make our resolutions, and maybe a few of us create new habits that will make us healthier, wealthier, and wiser going forward. Let’s hope so.

It also presents chief investment officers like me with the dubious honor of making predictions about the upcoming 12-month period. Even as I write this, I am reminded of the Mark Twain saying: “Prophesy is a good line of business, but it is full of risks.” Despite the risks—and with great humility—we offer our predictions on a few important aspects of your financial life.

The Stock Market: More Wealth, More Worry

Corporate profits are at an all-time high. U.S. gross domestic product is at a record high. Consumer income is at a new peak. And the stock market has set a new high.

For each of the last five years, investors have predicted that the stock market would return 7 percent in the following year. Recent surveys of Wall Street pundits arrived at the same result. I recently attended a lunch in New York City where 15 institutional investors predicted the average return for 2018 would be, you guessed it: 7 percent. And while the 10-year average return for U.S. large-cap stocks (as measured by the S&P 500) is close to that number, the last five years have averaged twice that, returning closer to 14 percent.

Few predicted the surge in earnings exceeding consensus that we saw in 2017, a key ingredient to last year’s stock market rally. Earnings were flat from 2015 to 2016, but in 2017, they grew 10 percent year over year. We expect another year of 10 percent earnings growth in 2018.

While stock valuations, as measured by price-to-earnings ratios, are higher than average, we concede that they have been still higher at times in the past.

One reason that investors are willing to pay higher-than-average multiples is the potential long-term increase in the earnings growth rate expected from the recently passed Tax Cut and Jobs Act of 2017. This new tax regime is a very big deal; it constitutes the greatest change in tax policy in the past 30 years. Some taxpayers will pay more, but almost all will pay less.

More importantly, changes in corporate tax policy should encourage investment in software upgrades and expansion of facilities. The recent emphasis on stock buybacks by corporations benefited shareholders in the short term—but it did so at the cost of reduced investment and lower potential for future earnings growth. The Tax Cut and Jobs Act of 2017 encourages reinvestment in the business, which should increase productivity, wages, and profits.

After reviewing multiple analyst estimates and the Tax Cut and Jobs Act of 2017 itself, we predict that its impact on future earnings will be larger than the market currently expects. Assuming we’re right, this surprise could bolster stock prices in 2018.

Interest Rates: Don’t Bet on It

The Federal Reserve, with more than 200 model-building economists, has predicted interest rates incorrectly every year for the last six. Fed economists have consistently predicted that the short-term federal funds rate would increase at a pace faster than bond investors expect. For example, three years ago, the Fed predicted that short-term rates would increase 3.25 percent—from 0.25 to 3.5 percent. They missed badly. The rate increased just 1.25 percent to 1.5 percent.

This year, at last, they might do better. If the Tax Cut and Jobs Act of 2017 incites enough economic activity to increase wages from 2.5 to 4 percent, rates could rise more rapidly than investors expect.

With the unemployment rate below 4.5 percent, the labor market is tight, and many firms have underestimated their need for labor. For example, both Macy’s and FedEx had to add extra workers for the Christmas rush. Macy’s added 7,000 more workers than they had initially estimated. Despite these facts, we do not expect wage inflation to be a factor this year—although we do expect it to rise to prominence in 2019.

U.S. Politics: A Divided Washington and United Wall Street

Predictions in the political arena have proven beneficial only for those with a strong appetite for humble pie. The 2016 presidential election results, the dramatic but short-lived equity sell-off on election night, and strength of the stock market—despite the March healthcare legislative defeat—have confounded investors and pundits alike.

At CAPTRUST, we feel it is imperative to put our political preferences aside and, instead, focus on the investment impacts of political outcomes. We ask ourselves whether a divided Washington can split a united Wall Street. Please allow us some latitude as we pose potential explanations.

Could investors both be vocal in political opposition to the Trump administration and still take advantage of the market and economic opportunities that the administration might create. For example, is it possible that banks and other financial institutions that take advantage of industry deregulation experience higher stock prices? We predict the answer is: yes.

Has a market consensus formed around the notion that the special prosecutor will not cause additional headaches for the Trump administration—and that price levels are safe from further political damage? Or, does the market believe that the special prosecutor will produce enough evidence to remove President Trump—but that a President Pence will adopt conventional Republican market-friendly policies?

This is a tough one to call. Paddy Power, a European betting website where punters recently proved more accurate in predicting both Trump’s victory and the Brexit vote, places the odds of Trump leaving office before the end of his first term at more than 50 percent.

Housing: A Spouse and a House

We predict that housing prices will appreciate in the mid-single digits in 2018. The tailwinds to housing are many and strong.

Surveys of Millennials, the 83 million Americans born between 1982 and 2000, show that this large generational cohort has the same four items on their wish list as past generations: a spouse, a house, a good job, and a secure retirement. Some Millennials had preferred—or were forced by tight mortgage credit standards—to rent rather than buy homes. Recently, however, they have demonstrated a clear preference for owning. The move-out rate from apartments to homes is at an eight-year high.

Federal Reserve regional economic reports cite the shortage of skilled construction labor as an impediment to increased construction of new homes. Too many apartments and not enough homes have been constructed in the last three years. As a result, the available supply of existing homes is scant. As you can see in the chart below, inventory has dropped from a 10-month supply seven years ago to a near-record low of less than a four-month supply today.

Existing Home Supply

Battle of the Giants: Bricks to Clicks

We predict that most of you will sample away from Amazon Prime and order a higher-priced item from Walmart in the next 12 months. Your actions, along with many others, could induce a very costly price war between Amazon and Walmart as they attack each other’s largest businesses.

Walmart is the leader in the grocery business. It has a 17 percent share of the U.S. grocery market—compared to Amazon’s less than one-half of 1 percent market share. With profit margins of less than 2 percent, groceries are a very low-margin business, but Walmart’s strategy is contingent on huge scale. And Walmart has 4,500 stores (compared to Amazon’s 100 stores). Meanwhile, Amazon has decided that it needs the Whole Foods stores’ physical storefronts and distribution system. Amazon is far behind Walmart by this measure and might need to invest billions in brick-and-mortar stores to compete.

Conversely, Walmart has decided to battle Amazon in online shopping by purchasingJet.com, an online retailer, to accelerate its growth. The retail behemoth now has 70 million items in its online store, and one-third of them are priced lower than the same products at Amazon. While that seems like a lot of SKUs, Amazon sells 480 million items and is adding nearly half a million items each day to its online catalog!

Amazon’s online sales were $38 billion last quarter; however while Walmart is far behind in online sales, it is improving rapidly. Walmart grew online sales by more than 50 percent quarter over quarter. But the company might need to spend billions to compete adequately in online retailing, reducing the company’s ability to increase its stock price through additional stock buybacks.

Both Walmart and Amazon must invest billions in these new strategies. But, if these strategies do not improve profits, both retailers’ share prices could suffer large losses.

Stay Wealthy: Don’t Wing It

A recent investor survey showed that most wealthy investors seek out and follow professional advice. Meanwhile, 8 percent of respondents replied that they just wing it. They manage their portfolios on their own. We predict that those who wing it will underperform those who follow a financial plan and invest in a diversified portfolio with a long-term investment horizon.

DALBAR’s annual Quantitative Analysis of Investor Behavior shows once again that the average investor’s behavior—driven by greed and fear—leads to poor returns. According to the study, the average investor underperforms the broad stock market by 3.5 percent each year, of which 1.5 percent is directly attributable to poor investor behavior. In other words: winging it.

At CAPTRUST, we are focused on analyzing portfolio opportunities in 2018. We are long-term investors, and we believe that a sound asset allocation strategy tailored to your specific needs and a long-term view can provide the confidence needed to maintain an investment plan.

The U.S. stock market performed quite well last year with less volatility than in recent history. To put that into perspective, the worst sell-off in 2017 was 2.8 percent; we saw that level of volatility on an average day back in 2008 and 2009. We are always on the lookout for catalysts, including a faster-than-expected increase in interest rates, intense political discord, and geopolitical flare-ups, that could cause market pullbacks or create short-term market turmoil.

As always, we will be following developments closely and will keep you informed. If you have questions or concerns, please do not hesitate to bring them to our attention.