With 2017 coming to a close, can investors expect another stellar year for stocks? Not so fast.
The Dow Jones Industrial Average surpassed 24000 points this year thanks to solid earnings, steady economic growth, subdued inflation and a careful Federal Reserve. Next year, market watchers say, tax reform, possible pro-growth initiatives from the Trump administration and an improving global economy could all prolong the current bull market in stocks, though likely at a more muted pace.
There are risks, however, that could upend this upbeat scenario. These include increased stock-market volatility, an unexpected spike in inflation or geopolitical turmoil.
The Wall Street Journal spoke at length with three financial advisers about how investors can prepare:
founder and chief executive officer at Beacon Pointe Advisors in Newport Beach, Calif.;
president and chief investment officer at Gresham Partners in Chicago; and
founder and chief executive officer at PagnatoKarp in Reston, Va.
Here are edited excerpts of that conversation:
WSJ: What do you expect for markets next year?
MS. EUSEY: We believe the economy and the developed markets should continue their steady advance in 2018. However, the markets are priced for perfection and we think any disappointing news will increase volatility.
The reason for the continued growth is that profits are strong. Employment continues to be strong. But that hasn’t translated into higher inflation. These all point to steady growth. We aren’t seeing any signs of recession soon.
We’re at historic lows in terms of volatility. So if we see any signs of an uptick of inflation, unemployment or any geopolitical concerns, we will see increased volatility.
MR. PAGNATO: We expect higher volatility. This year, the S&P 500 didn’t have a single day when it was up or down more than 2%. That’s incredibly low volatility. We expect the increased volatility to come from the central banks reducing the liquidity from the system.
More in Wealth Management
We feel domestic equities could see single-digit returns, primarily driven by a global synchronized economy, continued earnings growth and outside surprises to come from tax reform.
We do expect some deregulation to occur, particularly in the financial industry, which would be a positive tailwind to the markets.
MR. NEILD: The economy’s fundamentals are fairly positive. We just completed two consecutive quarters where GDP growth was over 3%. So that is pretty healthy, considering where we were coming from two years ago.
We’re finally getting to a stronger fundamental place from a corporate-earnings perspective. And, unlike earlier years in the cycle, what we’re seeing now is revenue growth. So this isn’t just about productivity and cost cuts. We’re seeing some headroom for earnings to grow because top-line revenue is growing.
Never say never, but it would be really hard for volatility not to increase. Think about all the geopolitical risk in the world today—whether it is Korea, China, or all the disruptions in Latin America, even right here at home. The markets are shrugging off things that they probably shouldn’t shrug off. And there is a sense of complacency out there that is a little bit troubling.
WSJ: Should investors cut back on stocks or boost their cash?
MS. EUSEY: Investors with a short time horizon should consider taking some money off the table if they don’t think they can weather a market correction.
Cash positions for us are a passive byproduct of where valuations are, not an active decision to de-risk the portfolio. So cash will be raised as we can’t find value in this market environment.
MR. PAGNATO: Valuations have been elevated for some time. And investors would have been penalized if they would have sold and went to cash. So we would not reduce equity exposure unless the client’s portfolio is unbalanced. It is actually a perfect time for investors to re-examine their risk and the allocations in their portfolios.
MS. EUSEY: We’re not raising cash solely based on valuation, but we want make sure every investment that we invest in has a margin of safety to the intrinsic value of the company. We are still finding value in the market in certain spaces.
MR. NEILD: Stocks are expensive. U.S. stocks, the S&P 500, more specifically, is trading around 18 times forward-four-quarter earnings—which, if you look at historical perspectives, is well above average. But before people start panicking, investors should recognize that high valuations are a notoriously bad predictor of market corrections.
With the exception of the late 1990s and early 2000s, where valuations were high and it did proceed a correction, a lot of the corrections that we’ve seen have actually occurred from lower valuation points. It is something else that triggered those. Starting in probably 2014 and certainly into 2015 and ’16, people were saying that the market was overvalued. And if you had actually left the market at that point in time, you would’ve missed two years of extraordinary returns.
WSJ: How should investors position fixed-income portfolios amid expected rate increases?
MR. PAGNATO: Investors should not abandon fixed income. We feel it is important to continue to maintain the discipline and have exposure there. These assets are an important element in a diversified portfolio and long-term interest rates really haven’t moved that much. The Federal Reserve raising short-term rates doesn’t necessarily mean long-term rates will go up. We view bonds that are longer term as a hedge against a potential market correction or decline in equity markets.
MR. NEILD: It has been four years since we recommended clients either move to a zero allocation of fixed income or the lowest possible allocation within their investment-policy ranges. It wasn’t a prediction about interest rates going up, but rather just a reflection on the lack of yield in the market. Today, you’re dealing with low interest rates, you’re dealing with compressed spreads. So the proposition of investing in fixed-income assets generally is pretty poor for investors today. We continue to recommend that either they avoid fixed income or hold near the bottom of the allowable range that’s consistent with their broader investment-policy parameters.
WSJ: Which stock-market sectors do you prefer now?
MS. EUSEY: Sectors that should relatively outperform if [President
] pro-growth initiatives go through are financials and materials. Other cyclicals, such as energy, should also benefit. We believe his pro-growth initiatives will continue to go through—and with the tax cuts all these areas will do well.
MR. PAGNATO: Banks will benefit from the tax-policy changes, deregulation and higher interest rates. We believe the continued deregulation will occur within the financial sector, which will present some good opportunities. A great way to invest in the banking sector is through preferred stocks. Technology should continue to deliver above-average earnings and sales growth in sectors like retail, automobile, energy, hospital, hospitality, transportation and leisure. It is those companies that are digitizing, that are embracing the technologies that are quickly rising to the top.
MR. NEILD: We don’t pick sectors. One of the things that we want do is to find managers who can rotate to better opportunities. And so we’d rather have them make that decision on a stock-by-stock basis rather than having a top-down view on certain sectors.
WSJ: What’s the biggest risk investors face in 2018?
MS. EUSEY: Equity valuations are stretched. The S&P cyclically adjusted price/earnings ratio is at 32, above where it was in 1929. The only time it has been higher was 1999.
So a reversion to the mean will likely happen, but that doesn’t necessarily reflect the health of the underlining economy. An unexpected spike in inflation is an event that could trigger a reversal of economic growth globally. It took nine years in the 1990s for us to see inflation and we are currently in the ninth year of our economic expansion.
MR. NEILD: You have elevated valuations across multiple markets. It’s not just isolated equity markets. In today’s environment, it is tough to find a place to hide. As valuations get elevated, you have more downside risk for investors. And you have to be careful about where you’re placing capital.
MR. PAGNATO: For us, the biggest risk for 2018 is if we get an inverted yield curve [when long-term rates are lower than shorter-term rates]. The last nine times the yield curve has inverted, we’ve gone into a recession.
So if you look at where interest rates are today—the 10-year Treasury note is at 2.3 something, the 30-year Treasury bond is at 2.7 something—it isn’t that far away. If it happens, there could be a domino effect in other markets.
WSJ: What effects will the corporate tax cut have on the economy and for investors?
MR. NEILD: There will be a positive effect on earnings for many publicly traded and privately owned businesses. It will have a significant effect on the perception of market valuations. In theory, companies will have additional capital for investment and hiring, but there is no requirement to deploy capital in this manner. But it could have a substantial beneficial impact on stock-market levels.
MR. PAGNATO: We are advising business clients to be on the lookout for any potential business expenses that can be escalated into the 2018 tax year. [The lower corporate tax rate] will be a stimulus for the economy. Consumers will have more discretionary income to spend. Businesses will have more cash flow and net income. This will lead to increased distributions to shareholders and more capital to reinvest in the business.
MS. EUSEY: While it should increase business and consumer confidence, the positive impact on the overall economy will likely be marginal at best. Corporations have quite a bit of cash. To spur economic growth, corporations will need to reinvest in their companies. What does help is that the tax cut makes the U.S. more competitive as we currently have one of the highest corporate tax rates. …Will they take the profit for themselves as bonuses, or pay dividends, buy back shares, or will they hire, pay higher wages and make capital investments? We haven’t seen increased profits in recent years necessarily being used to grow businesses by investing in people or capital.
WSJ: How much should investors allocate to foreign?
MS. EUSEY: We are recommending increases in that asset class. Parts of Southern Europe may still have underlying problems, but overall, the economies are improving there. The longer time horizon a client has for emerging markets, the better off they are, because the demographics are changing in a positive fashion.
MR. PAGNATO: We’re recommending the average investor put 35% into foreign investments. We continue to believe that emerging markets will do well. Emerging markets are trading around 12 times earnings, whereas the U.S. is 18, 19 times.
MR. NEILD: We have a significant portion of our clients’ portfolios allocated to international. In a traditional equity portfolio today, well over half. At the core, valuations in the U.S. are more stretched than in other places in the world.
Emerging markets, despite their run this year, we think have a long way to go. Most people, when they think about investing in markets like this, will invest in an ETF or a mutual fund. The challenge with that is that the benchmarks in emerging markets are just horribly constructed. They are energy companies and financials. They are typically state-owned companies that are poorly run, they’re slow growing. These are exactly the companies you don’t want to invest in when you’re thinking about the opportunities in emerging markets. What you’re after is this emerging discretionary spending, this emerging middle class that creates enormous inflection points in consumption. Those companies, historically, haven’t been represented in those benchmarks. So you have to think a little bit differently.
WSJ: Are there any specific markets abroad that you like?
MR. NEILD: China and India would be at the top of the list. China is fascinating because of what’s happening with the opening of the market to foreign investors. We think that market, over the next five to 10 years, will be an enormous opportunity, both from a traditional sort of stock-picking perspective, but also as the market evolves and matures, you’re starting to be able to short some of these securities through offshore mechanisms.
WSJ: Opportunities in alternative investments continue to expand. Are you recommending any particular instruments?
MR. PAGNATO: We believe ultra-high-net-worth individuals should be allocating somewhere between 5% and 25% of their assets to alternative investments. This capital is going to be tied up between five and 10 years, so it is really important that they understand that time frame and that it isn’t liquid. Strategies range from private equity and venture capital to mezzanine debt to high-yield municipal bonds to private real estate, infrastructure, and some hedge-fund strategies.
MR. NEILD: We don’t think about alternatives as an asset class or an allocation. We actually will look to try to understand the underlying risks and opportunities.
Our view on hedge funds for the past six or seven years has been that they’ve been a disappointment to investors. If you look at the excess return that has been generated, most of that has gone to the managers in the form of management fees and incentive fees. So the investor in an average hedge fund would probably have been better in just a simple sort of passive stock and bond portfolio, which is really an indictment of the industry itself.
Having said that, there are a number of really talented hedge-fund managers. And if you can get to them, you can make a material difference in a portfolio allocation.
WSJ: What’s your view on bitcoin and other cryptocurrencies?
MS. EUSEY: It isn’t an investment we would make as a stand-alone investment. It doesn’t have any political or economic backing. And it is obviously highly volatile. We are excited about the [blockchain] technology [behind it] and what it may provide for a number of industries, including financial services.
MR. PAGNATO: There are some technology attributes—removing the middleman, transparency—that I think are going to be very viable for the blockchain technology. But we’re not advising clients to invest in it at this point due to the extreme volatility.
MR. NEILD: It’s a speculative instrument, it isn’t an investment at this point. It is an incredibly exciting ecosystem that is being developed around blockchain and cryptocurrencies. We have a number of managers, particularly in venture capital, who are funding lots of startups in this environment. The challenge is you don’t know which one of those work. What you’ll probably see is the typical high failure rate of a venture-capital portfolio being applied to this sort of environment.
WSJ: The tax-reform plans recently passed by the House and Senate must still be reconciled, but so far each would curtail individuals’ deductions for state and local taxes. The House bill caps the mortgage interest deduction at loans of $500,000. The Senate bill retains a $1 million threshold. Are any of you recommending certain steps at this point?
MS. EUSEY: Most people pay their state taxes before year-end. I would suggest if that is not something you do, you pay them this year to get the deduction. We also are recommending setting up a donor-advised fund if you’re charitably inclined and you do itemize your deductions because that is something that you likely may not be able to do going forward.
MR. PAGNATO: We’re recommending that clients escalate as many itemized deductions as possible in this calendar year.
MR. NEILD: It’s pretty clear that charitable deductions won’t be more valuable next year. To the extent that there is a way to accelerate them, where it is through a donor-advised fund or whether it is just through a simple acceleration of donations that you’re already planning to give, avoiding things like the alternative minimum tax, do it this year.
WSJ: Do you have any advice for those considering buying a home?
MR. NEILD: I think a reduction in the deductibility of state and local taxes will actually have an impact on home values in certain states.
MS. EUSEY: It’s going to take some financial-planning efforts to make sure that buying a home is actually more valuable than renting a home for the investor.
WSJ: Any other year-end moves you’re talking about?
MR. PAGNATO: Investors should be doing portfolio tax-loss harvesting. It’ll be more challenging this year because of all the appreciation of asset classes. When gifting, an investor should look through their portfolio, really consult with their adviser to ensure that they’re gifting highly appreciated assets, as opposed to just cash. Last would be to consider whether they are eligible, based on their income, for a Roth individual retirement account conversion.
Ms. Maxey is a Wall Street Journal reporter in New York. Email: email@example.com.