Once a year it is easy to select a title for this letter. Each year at this time, we find it instructive to review our forecast from a year ago compared to what actually happened. It helps put things into context as we make our fearless forecast for the New Year. This year, we did pretty well.
For 2017, we will give our forecast an A-. This is the second year in a row for that high mark, which should give you pause as you read the rest of this letter! We got the economy right. We expected GDP to grow about 3%. We expected earnings to be great. We thought unemployment would move below 4.5%. Inflation would accelerate and labor costs would move up faster than inflation. We also expected tax reform, both personal and corporate to be accomplished by the end of the year.
We thought that the Federal Reserve would raise overnight rates to 1.5%, and that the ten-year US Treasury note would yield 3% by year end. We were right on short-term rates, but wrong on the ten-year which ended the year essentially unchanged at just under 2.5%. Our target for the S&P 500 for the end of 2017 was 2450. That would have been great, but we underestimated the earnings power of synchronized growth throughout the world. And, we underestimated the effect that a pro-business administration would have on market psychology as regulations have been pared back and corporate taxes lowered. Stocks ended the year at 2668 on the S&P, some 8% better than our forecast. It was a super year that continued the long Bull market started in 2009. We also said that gold, and oil would enjoy good gains throughout the year.
Our A- might have been an A, but we were not sufficiently optimistic on stocks, and were too pessimistic on bond yields. Those things are likely related. But, at least you could have done OK with our forecast, given some small opportunity cost associated with our conservative bent. This year will be harder!
It is unlikely that 2018 returns on US stocks will match the 20% returns on the S&P 500 this year. The market is a forecasting mechanism. It has already borrowed some return from 2018 anticipating the corporate tax cut. In addition, the tech sector is now close to 30% of the Index, and it was up 50% in 2017. Tech led all large capitalization growth stocks to a 28% return, while value stocks did 17%. The S&P won’t enjoy the same ride from its largest sector in the coming year. Instead, value will continue its recent relative return catchup that began in recent weeks. Financials, basic industries, commodities, energy, etc. should continue to be better performers as the economy enjoys strong growth.
The economy should grow at 3.5%, with unemployment reaching 3.5% by year end. Inflation will continue to ratchet up toward 2.5%. And, the Federal Reserve will keep raising rates. Expect the overnight Fed Funds rate to reach 2-2.25%. Ten-year US Treasury note yields will finally reach 3%. Earnings for the S&P 500 stock index will reach at least $150 per S&P share with the tax cut. In 2019 earnings could grow to $163, or so. That would be helped by a recovery in earnings for basic industries, especially energy. Foreign company earnings and stocks should continue to do well also as global economic growth accelerates.
Oil will trade in a range of $50-70 per barrel. It is likely to move toward the high end of the range in summer just as Saudi Arabia manages to sell a piece of ARAMCO. Gold and other commodities should do well. Gold should outperform both stocks and bonds. The surprise of the year could be a breakout in commodity prices including grains.
Taxable bonds will likely not return their coupon interest on a total return basis. But for income investors, the principal risk is not great. That is especially true for municipal bonds. With the recent tax changes, tax free income for high income taxpayers will become more precious as they lose state and local tax deductions. Yields on tax free bonds should decline relative to taxable issues, offsetting some of the interest rate risk. Closed-end municipal bond funds are especially attractive with current tax free yields of about 5% and selling at a discount to net asset value of 10%.
As yields rise throughout the year, they will become problematic for stocks. There will finally be some competition for marginal investment dollars. The five-year Treasury note at 2.25% yields more than the dividend yield on the S&P 500 for the first time in many years. This will hold down the forward price/earnings multiple for stocks. So based on forward earnings of some $160 per share, the S&P might have a PE range of 15-18 times throughout the year. That would be a range of 2400-2900 for the index. We would expect a correction in late January into February which will be a buying opportunity. We would expect a move toward the high end of the range in summer. After that, things could potentially get messy due to the midterm elections. The administration has had some solid accomplishments, but investor confidence could falter as the risk of a Democrat takeover of either, or both houses of Congress looms.
We don’t see anything that points to a big decline in stocks. There remains a “shortage” of publicly traded stocks as we have discussed before. There are twice as many mutual funds and ETFs as there are individual stocks in the US.
A significant amount of the soon to be repatriated overseas funds will go toward stock buybacks decreasing the supply of stocks even more in the short run. 2018 will be a more “normal” year for stocks than we have seen since the Financial Crisis. Since the bottom in March of 2009, the S&P 500 has enjoyed an annualized return of 19%. If we get half of that next year we should rejoice!
Have a healthy and prosperous New Year!