5 Things to Watch in the U.S. Equity Markets in 2018

Written by: Chaikin Analytics

1. The bull market is maturing, but is not over yet

The adage that “bull markets climb a wall of worry” held true in 2017, as political strife in Washington crescendoed to a level not seen before, geopolitical factors worsened, and the rally to new highs brought out the bears in the media. Ultimately, fundamentals drive stock prices and with the U.S. economy on solid footing, coupled with ongoing growth in both top-line revenues and bottom line earnings, fundamentals are supportive of continued upside for equities.

History indicates bear markets rarely materialized, while the economy was expanding. We believe it is unlikely this time will be different. Amid lower corporate taxes and easing regulatory burdens, the earnings picture continues to look good for U.S. stocks, which we believe will be a continued tailwind for higher stock prices.

The S&P 500 is on a torrid pace. The last time the U.S. equity gauge benchmark declined on a monthly basis was November 2016, and the last 5% decline was back in June 2016, during the Brexit imbroglio. This year, we believe there are likely to be one or two declines of 5% to 10%, but in the context of a positive year, those declines will be buying opportunities.

Overall, 2018 should be a continuation of the earnings-driven upside delivered in 2017, supported by expanding top- and bottom-line numbers.

S&P 500: positive Sales Surprise (% of Companies)

2. Picking winners/avoiding losers is increasingly important

In any environment, it is important for investors to identify winning stocks, while avoiding losers. That is increasingly true in an aging bull market. Different factors become important to identify in a mature bull market, and finding stocks with a good growth to value trade-off will take on more significance. We believe having a repeatable and consistent process is the key to making money over time, especially in late-stage expansions.

Historically, technology and industrials are among the sectors that performed well in mid-cycle stages while materials and utilities lagged during those periods. As the cycle advanced to its later stages, economically sensitive sectors, such as energy and materials, performed well, as did defensive groups, such as consumer staples, health care, and utilities.

3 Trees don’t grow to the sky. Neither do stocks.

Much of the 2017 upside in U.S. equity markets was attributable to the FAANG stocks (Facebook, Amazon, Netflix, and Google). These are incredible growth stories with solid management teams, but while we believe earnings and revenue growth is likely to continue for these companies, regulatory headwinds linger. At some point, popular stocks, like the FAANGs, become fully priced, and 2018 may be that year. We believe that 2018 will bring more differentiation to stock performance and the overall returns of the market will be less dominated by a few mega-cap stocks.

4. Value looks to beat growth, and size matters

Investors look at many style-based factors to see what areas of the market have been outperforming or underperforming. Factors such as size, growth versus value, beta, momentum and dividend yield, are all cyclical, with leadership dominating for a year or two, and then lagging for a period of time. Last year, the growth factor dominated value, while large caps topped smaller stocks. For example, the Russell 1000 Growth Index gained 30% last year, or more than double the 13.5% returned by the Russell 1000 Value Index.

Value has been trailing growth for two years, due in large part to technology's leadership. We believe 2018 will bring a reversal of value and the small-size factors' laggard ways.

As this bull market ages, we believe investors will pick up cheaper segments of the market, bidding up value stocks relative to growth names. Additionally, there are some great opportunities in small caps, with the new corporate tax rates benefiting smaller companies, as they can’t play the same tax games as large multi-national companies who use overseas subsidiaries and other tax-avoidance techniques to lower their overall tax rates. Furthermore, small caps have historically outperformed large caps when interest rates rose.

5. Embrace solid fundamentals

This is the right thing to do all the time and is not just a 2018 story, but it takes on increased importance in the late stage of a bull market. The old adage “a rising tide lifts all boats” can be applied to stocks. In new bull markets, many investors simply “buy the market,” but as the bull market advances, there are potential rewards for tactical investors. In 2018, it will be critical to buy stocks that have solid growth prospects, balanced with reasonable valuation factors and encouraging technicals. Fundamentals drive stock prices, so focus on stocks with strong fundamental factors in strong sectors and industries.

Disclosure: Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
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IHS Markit Purchasing Managers’ Index (PMI) is based on monthly surveys of carefully selected companies representing major and developing economies worldwide.
S&P 500 is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.
Russell 1000 Growth Index is an index of approximately 1,000 of the largest companies in the U.S. equity market.
Russell 1000 Value Index refers to a composite of large- and mid-cap companies located in the United States that also exhibit a value probability.
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