As 2018 began, I published My Gut Feeling For 2018. Now that 2018 is in the books, I wanted to look back at how my expectations and predictions fared in 2018. Recall these predictions were made in the spirit of the old Wall Street Week with Louis Rukeyser show in that they were fixed a year ago and could not change. The original commentary is in lighter print and in bold italics are the comparison to actual results and explanation, as warranted.
- The SPX ended 2017 at 2,673.61, which using Bloomberg’s Standard & Poor’s 500 (SPX) earnings estimates of about 119.16 implies an index price/earnings multiple (PE) of 22.44. Standard & Poor’s own analysts estimate that SPX earnings for last year should come in at 124.94 implying a year-end index PE of 21.40. Last year I was expecting EPS of 130 with a lower PE ratio of 20. Thus, I was over on the EPS but conservative on the PE for the SPX. Looking forward to 2018, bottoms-up earnings as complied by Standard & Poor’s, for its SPX index, are expected to increase by about 13.01% to 141.19. Bloomberg’s estimates call for SPX EPS of 147.99. The backdrop for financial markets in 2018 will be implementation of the new US tax legislation and a coordinated global economic expansion. My expectations are that SPX will earn 145 in 2018. Applying an earnings multiple of 21, I am setting a year-end target for the S&P 500 at 3,045, about a 13.9% year-over-year increase. Get your SPX 3K hats ready. With all that said; expect a correction of 5 – 10% during the year which will be unexpected, quick, and temporary. – There is plenty to review here, so let’s take it one piece at a time. SPX earnings greatly benefitted from the Tax Cuts and Jobs Acts of 2017 and reduced government regulation. However, a recalcitrant FOMC did its best to choke off the United States economic machine; despite a lack of economic overheating and discernible inflation. Those actions could not slow down jobs growth, labor participation and an increase in factory output. However, it did slow down the bull market in stocks. Bottoms-up SPX EPS as calculated by Standard & Poor’s in 2018 surged 26% to 156.99 (estimated). As per Bloomberg, SPX EPS was approximately 146.43. All told, my EPS estimates were a bit low. The SPX index hit an all-time high of 2,940.83. That unexpected, quick and so far, temporary 10% correction (nearly 20%, in fact at some point) did take place. The stunner was the rapidity of the decline and timing of the correction which took place in the 4th quarter. So, we got no SPX 3,000, but that is only a matter of time. I think my big mistake for 2018 was applying such a high PE ratio. Hence, while earnings did surge, the market was only willing to pay 16 – 17 times for those earnings.
- The Federal Reserve Open Market Committee (FOMC) raised its short-term Fed Funds rate three times in 2017 and five times since interest rates bottomed out at zero in 2015. Fed Funds now stands at 1.25%. The FOMC will be headed up by a new Chair in 2018, Jerome Powell. I expect three rounds of 25 basis points tightening in 2018, with Fed Funds ending the year at 2.00%. Other major central banks around the world will also begin to raise their target interest rates as their respective economies exhibit improvement. – The FOMC raised it’s Fed Funds target by 0.25% four times in 2018. The last one broke the camel’s back, so-to-speak and caused the 4th quarter market downdraft. New Federal Reserve Chairman, Jerome Powell has not gotten off on a good footing; clearly not endearing himself to the financial markets and politicians.
- Despite the FOMC hiking short term interest rates three times in 2017, insatiable appetite for US Treasury securities keeps on propping up that market, Hence, the bond bull market dating back to the early 1980s is still hanging on by a thread. Furthermore, the yield curve continues to flatten rather than widen. We should expect a widening of the yield curve during an economic expansion. All told, the US Treasury market befuddles me. Still, I am going to cling to my belief that the curve begins to shift higher, but the slope of the curve will remain much the same, at least in 2018. If you must invest in fixed income, keep maturities to five years or less. By the end of 2018, I expect the US Treasury market will yield as follows: 5-year 2.50%; 10-year 2.75%; and, 30-year 3.00%. – That insatiable appetite for US Government Securities remains unabated, and has spread to the mortgage markets, thanks in most part to the rising US Dollar and a flood of liquidity into the bond coffers of pension funds. By the end of 2018, the US Treasury market yielded as follows: 5-year 2.51%; 10-year 2.69%; and, 30-year 3.02%. I was quite close with my predictions in the bond market, just missing those benchmark US Treasuries by a few basis points.
- We are still in a growth-oriented market. Also, we remain in an investment mode which favors large cap stocks. Thus, on a macro basis you want to continue to favor exposure to SPX, Dow Jones Industrials (DJIA), and NASDAQ 100 (NDX). – while the markets remained in growth mode from an earnings perspective, the market was not willing to pay for such growth in 2018. All three major indexes were lower on the year with the NDX posting the smallest of losses of 1.04%. With a year-end PE ratio of about 16, the SPX enters 2019 at its cheapest valuation since the bull market began in 2013 (remember that it is a misnomer that it began in 2009)
- On a micro basis, it is prudent to shift allocations away from large cap technology where we are overweight, into more thematic sectors such as infrastructure, energy, restaurants, and financial services. We are not abandoning large cap tech, just harvesting some outsized gains to reallocate into some other sectors which have been laggards for the past several quarters. On a selective basis, there will be some excellent opportunities in individual small and medium cap stocks, but I would continue to shy away from those sectors on a macro basis. – As the year progressed, I kept my allocations to growth-oriented sectors. Any forays into financial services and energy were brief and small. Those sectors were underperformers and might remain in the dog house for 2019.
- At some point this year, the US economy will reach escape velocity. Economic growth will be consistently above 3% on the road to at least 4%. This will be due to continuing job growth, benefits from the new tax law, strong consumer confidence and resurgence in the economies of Europe and Asia. I expect GDP in the US to grow by: 3.2% in 1q; 3.5% in 2q; 3.7% in 3q; and 4.0% in 4q. – From my perspective the economy did reach escape velocity. However, by year end, potential tariff issues (I say potential because we only had threats of a tariff war, but no actual tariffs of significant magnitude were enacted, especially with China) and the dogmatic FOMC might have slowed down GDP growth a bit in the 4th quarter. Real GDP in the US grew by: 2.0% in 1q; 4.2% in 2q; 3.4% in 3q; and I expect 3.5% in 4q (we won’t get the first advance estimate till January 30, 2019).
- Energy prices will creep higher and break out of a long-term trading range. Crude oil prices will trade between $60 and $75 for most of the year because of escalating global demand. The sweet spot of the energy markets will be in the midstream. This sector comprises refining and chemical production which plays into the themes of higher economic growth and infrastructure rebuilding. For example, we have already begun to take positions in Marathon Petroleum (MPC). – Indeed, Crude Oil prices traded in the $60 to $75 range from January to the end of September 2018. Then the bottom fell out of the market as record amounts of crude oil supply flooded the market and the price crashed to $45.41 by year end, a year-over-year decline of almost 25%.
- In US politics, there will be the mid-term elections. As is usual, the party in the White House should lose some Congressional seats. With that in mind, let’s not forget that the Democrats are defending twenty-seven of the thirty-five seats up for reelection (that includes independents and a special election in Minnesota), so their task is a difficult one. Should on the other hand, the Republicans maintain control of both houses of Congress or gain some seats, the markets will get an adrenaline rush. I place a 60% chance of the first case occurring and 40% of the second case materializing. Either way, let me remind everyone that the strongest quarter in the sixteen-quarter election cycle is that of the fourth quarter in the midterm election year, so be prepared to get aggressive on September 30. The last time that the SPX declined in the fourth quarter of a mid-term election year was 1994. – The Republicans held control of the Senate and even added a few seats in the midterm election. On the other hand, the Democrats flipped the House of Representatives, creating a divided government. Technically we had a dividend government before as the Senate requires sixty votes to end a filibuster. Because of all that I mentioned above, the strong midterm fourth quarter never materialized in the stock markets.
- Overseas, there will be two surprises that the markets have not yet factored in. First is that North Korea’s Kim Jung Un, for all his bluster, will come to face the reality of: American military superiority, economic pressure from China and President Trump’s firm stance; to come to the bargaining table with South Korea. The second surprise will come from Iran where a new secular revolution will overthrow the existing religious government, a reversal of the 1979 Iranian Revolution. In general, increasing exposure to international markets via exchange traded funds will be another strategic opportunity worth considering. All told, I have already begun to lighten up positions in defense stocks as they will fall out of favor if one or both of those international events take place. – It is fair to say I got a check plus for this prediction. President Trump made huge progress with North Korea’s Kim Jung Un. So much so, that test firing of rockets ceased, and the two leaders met. This spurned more discussions between the governments of North and South Korea. Iran is feeling the pain of economic sanctions and the abandonment of the Iran nuclear deal in May 2018. Civil unrest is beginning to fester in Iran. If you think that the US markets were challenged in 2018, the overseas markets were even worse. I never dipped a toe outside of the US.
- There will be major changes in the US Supreme court where two seats will open, most likely that of Anthony Kennedy and Ruth Bader Ginsburg. – Anthony Kennedy retired and was replaced by Brett Kavanaugh after a contentious three-ring circus nomination process for which we will never forget. Ruth Bader Ginsburg is hanging in there but for how long we do not know. I would not bet that she lives past 2020 as her health continues to falter. I do look forward to seeing her biopic, On the Basis of Sex.
Disclosure: At the time of this commentary Scott Rothbort, his family and/or clients of LakeView AssetManagement, LLC was long DIA, DDM, UDOW, QQQ, QLD, TQQQ, SPY, SSO & SPXL although positions can change at any time.
Scott Rothbort is the President & Founder of LakeView Asset Management, LLC, a registered investment advisor specializing in high net worth private wealth management. For more information on investing with LakeView Asset Management, LLC call us at 888-9LAKEVIEW or request more information by clicking on the contact button on the top right-hand corner of the website. LakeView Management, LLC is a Nevada LLC, with its principal office located in Henderson, NV and branch office located in Millburn, NJ
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