Thinking About 2018

Published On: December 19, 2017

Written by: Ben Atwater and Matt Malick

Nobel Laureate Economist and Yale University Professor Robert Shiller is working on a new book about markets and narratives.  In this context, a narrative is the story that people superimpose during various market stages and cycles.  Recently, we have been thinking a lot about narratives, whether they apply to the broader markets or to individual stocks.

For example, in our view, the 2017 narrative surrounding markets goes like this:  Tax cuts will be a boon to investors and corporate America.  Amazon and a handful of other growth companies are ascendant and indomitable.  Worldwide economic growth is coordinated and persistent with no recession on the horizon.  Permanently low interest rates justify high valuations for stocks, real estate and any other imagined asset classes, such as cryptocurrencies.

We are grateful for the 2017 narrative and, overall, we don’t blindly take exception to it.  But, we are ever cautious amid what we believe is increasing market euphoria.  Beginning in March of this year, we sent several notes, like this one, where we suggest some caution in what is by historic measures (like market-cap-to-GDP and the cyclically adjusted price-to-earnings ratio) an expensive stock market.

Our vigilance is part of our duty to be responsible stewards of your money.  We can’t emphasize enough our overwhelming belief that long-term financial and investment success is about steadiness, consistency and not making big mistakes.

As the bull market gets older, the temptation to get caught-up in fairytale narratives increases.  Back in 2013, a great year for the market, most investors barely noticed that the market was up.  It was virtually unspoken.  Even last year, 2016, very few people observed how healthy market returns were.  In 2017, every day is a headline about all-time highs.  Money is flying in all directions, much of it headed for disappointment.  We were far more excited about the market in 2013 than we are in December of 2017.

Nobody can time the market or make predictions with any degree of proven accuracy.  It is prudent to always be in the market, even when it’s expensive, because equities can go higher and higher despite rich valuations.  That said, it’s vital to remain mentally prepared for what can happen to stocks (they can go down, by a lot, at any time).

Although we offer it only as a possibility, the narrative in 2018 could change.  For example, big corporate tax cuts could be the ultimate “buy on the rumor, sell on the news” trade.  Sure, many of the companies we own will enjoy massive tax cuts – particularly companies with large domestic businesses.  Generally, these tax cuts will lead to a one-time substantial increase in reported earnings.  However, this could already be priced into stocks, we don’t know.  From the perspective of 2018, tax cuts could be anticlimactic.

Another potential change in the narrative involves fear about the structure of interest rates.  Over the last six months, the yield curve has flattened tremendously.  A two-year U.S. Treasury note yields 1.82% while a ten-year U.S. Treasury yields 2.349%, a difference of only 53 basis point, slightly more than half of one percent.  This tells us the bond market (the larger and “smarter” market by most accounts) is hardly optimistic about future economic growth and inflation.  In the past, a flattening yield curve has been an ominous sign.  If it continues to flatten, and commentators decide to focus on the flattening, stocks could suffer.

A litany of exogenous factors, which are even more unpredictable, could also change the market narrative quickly.  Our point is that sentiment (via narrative) can change at any time and can change drastically.  All we know for sure is that it will change, but we have no idea when.  It could be 2018, it could be 2020.  It is also worth noting that the higher prices get, the less safe any market becomes.  Unfortunately, investors get confused and find reassurance in higher prices, when the opposite is true.

Our general plan for 2018 is three-part.  First, we should have some percentage of money set aside in a safe place (short-term bonds) to put to work when the market falls.  We will miss some upside, but we will have dry powder on a rainy day.  Second, we are looking to increase diversification by incrementally adding additional stocks to portfolios.  We are doing this by reducing overweight stock positions.  Third, owning companies that have an intrinsic value (that pay a dividend and have positive free cash flow) should provide a cushion in the event that the market falters.

Make no mistake, these are great times for investors.  We can continue to do very well over the long-term, if we keep our heads about us.

 

 

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