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Animal Spirits

Happy New Year!  I wish you a peaceful and prosperous 2018.  Looking back, 2017 was prosperous for US investors, as stocks generated a total return of 21.8%, measured by the S&P 500.  It was a good year, by historical standards.  Over the last 30 years, stocks have averaged a total return of 12% with an annual standard deviation of 17%.  Other years with big returns, such as 2009, 2003 and 2013 to some degree, were classic rebound years.  Then, there was the stratospheric run in the late 1990’s when stocks averaged 28% returns for five consecutive years.

What drove stock prices in 2017?  There were several things that cumulatively led to a “perfect storm” for stocks: the US $ weakened against most major currencies, oil prices moved back into a range supportive of normal capital spending, OECD countries collectively grew, US corporations experienced double-digit earnings growth after several flat years, the prospects of corporate tax cuts stirred animal spirits, interest rates remained low and the Federal Reserve was somewhat accommodative, all with a general backdrop of full employment and improving consumer sentiment.

What should we look for in 2018?   According to FactSet Research, Wall Street analysts are forecasting S&P 500 earnings growth to continue at an 11.8% clip, with energy, materials, financials and info tech leading the way.  Stocks with higher international exposure generated superior earnings growth in ’17 and this is expected to persist in 2018.  Analysts’ estimates are for continued double-digit growth and $146.60 per share in 2018 and $161.30 in 2019.  Stock investors are thrilled to move on from the meager 3.2% pace of growth from 2012 to 2016.

The tax cuts recently passed by Congress have long been anticipated by investors.  They will fuel investor optimism for a time – until the true benefits to corporate earnings and household wallets start to pencil out.  Sadly, elected officials in Washington have given up on any sense of fiscal discipline.  The federal deficit is north of $20 trillion.  Tax cuts will unnecessarily increase the deficits (both financial and environmental), lead to higher interest rates and inflated costs (housing) and cause more sensible governments in the future to have to raise taxes to account for this generation’s need to have it all, now.

On the immediate horizon, there are flashing yellow lights – things to watch for that may stall the stock market juggernaut.  Unemployment is low, and the number of job openings is near record levels.  Labor force growth, a critical element in the economic equation, continues to decline.  With no constructive immigration policy, higher wages will ultimately spark inflation and hamper profits. In response to an uptick in inflation, the Federal Reserve will likely raise rates, making credit more expensive.

We are also faced with a chaotic backdrop that many people cannot embrace.  There is a lingering feeling of apprehension continually poked by twitter trolls and divisive memes.  The trend is troubling and mirrored to some extent in the Bitcoin bubble – an emerging tendency for people to put more faith in computer code than human institutions.  Technology is driving change that we are only beginning to understand in retrospect – there is risk these uncharted waters continue to disrupt.

My view is we have to rely on what we can measure.  The market has been trending higher, so like a good angler, the trick is to play out slack.  I think we have to defend against complacent thinking and remain disciplined.  Early this year we will be busy resetting asset allocations that have become stock heavy over the past 18 months.  This will require trimming some of our big growers, and repositioning to allow for more growth/value balance in your portfolio.  Capital gains taxes have not changed, and this works to our advantage.

There is an old stock market truism, “pigs get fat and hogs get slaughtered”.  As is the case, with heightened returns come animal spirits.  Our job, at the moment, is to defend against greed trampling common sense.  I have confidence in our process, and would be happy to review your asset allocation with you, necessary cash levels and tolerance for capital gains, as we start the New Year. 

Bruce Hotaling, CFA

Managing Partner

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