As a general rule, we are not big fans of giving market outlooks. Our view is simple: Markets for securities are inherently volatile and capricious. Some days, weeks, months, years they go up. Others down. The market is like a giant scale that constantly weighs information but can take years for the scale to accurately settle. Over 10,20,30 year periods the market will reflect the compounded profit and interest in a very effective manner, but the short run is extremely unpredictable. Allowing the wonder of time and interest to work in your favor is the greatest advantage investors hold. Making sure we own companies with strong balance sheets and business models are the second great advantage we hold.
Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it. Compound interest is the most powerful force in the universe. – Albert Einstein
This does not mean we should ignore market activity. We aim to capitalize on short-term inefficiency created from the market bouncing around to capture and enhance the long-term effects of compound interest. Our job, in short, is to always keep emotion away and allow compounded interest to work its magic while constantly looking for small enhancements created from short-term volatility. For this opportunity seeking, we move forward with our 2018 outlook.
Economic Movement – The BIG Variables
- Monetary Policy: Federal Reserve Actions / Interest Rates
- Fiscal Policy: Government Spending / Taxes / Regulations / Trade
While 2017 experienced support from the monetary, fiscal and regulatory policy. The combination of low rates, reduced taxes, and reduced regulations served as a tailwind for the economy. Moving forward, we are unlikely to see this level of support in 2018. The question becomes….can the 2017 changes create the framework for sustainable economic expansion? So far in 2018, we have seen a reverse of the 2017 trend with tighter monetary policy and trade/tariff tensions. Will the tax benefits, corporate earnings, and the American workforce overcome rising rates, increasing the national debt and tighter trade? No one really knows the answer to this question. However, the data seems to indicate slightly higher rates will offset some, but not all, the benefits of lower taxes. Reduced taxation (corporate & personal), lower unemployment, and some wage growth will all add to increased consumption in 2018 that likely keep the economy stable and provide a solid floor for investment growth.
Investment Valuation – Flip Side of the Economic Coin
The earnings yield of the S&P 500 was 4.25% on October 1st, 2017. After recent Q4 guidance adjustment, the forward projected earnings yield for 2018 is 5.32%. This represents a large projected jump in earnings for Americas largest companies. Our biggest takeaway is the relative strength of companies. If rates remain somewhat accommodative and we do not see a major fall out from recent trade and tariff talks, then 2018 holds the potential for a continued upswing. However, we expect much higher volatility in 2018 as compared to years past.
Investment Expectations – Lower and Rising Rates Reduce Growth
With an earnings yield between 5-6% for stocks and the 10-year treasury bond at 2.87%, it is probable that the general stock market will return 5-8% over the next 3-5 years while the general bond market may struggle to get 3-4%. Our expectations for a balanced portfolio (60-70% stocks with some risk-reducing bonds or annuities) are currently around 4-6%. This is significantly below the historical balanced 60/40 portfolio return of 9.5% (from 1970 to today) or 7.4% (1990 to today). Thankfully we have been very conservative with all client planning rates over the past 5 years in anticipation of lower forward returns due to lower rates. So while these rates are reduced from historical norms, they continue to meet client objectives and provide the best road for beating inflation long term.
Investment Action – Opportunity on the Horizon
Everything mentioned above is a normal and healthy part of business cycles. The labor markets worldwide are reaching all-time low unemployment. Interest rates are increasing and monetary policy is tightening. At some point, the weight of higher rates and reduced labor force capacity will tip the economic scales and reverse the cycle. Companies will need to start laying off employees to keep meeting profit expectations, they will stop issuing bonds for expansion, consumers will slow spending, profits will decrease and a recession will begin. As markets react, the opportunity will become obvious. We will have a chance to buy some wonderful companies at great prices. The cycle will stabilize, rates will decrease in response to less supply of bonds, homes will become cheaper to buy, consumers will start to spend again, companies will see profits and the recession ends. This cycle has played out many times and we are prepared to use the cycle to our advantage. Those who have a healthy understanding and emotional control stand ready to take advantage of opportunities. We have experienced a tremendous run-up in all accounts over the past 9 years. We are positioning in strong companies that will weather the next storm as we wait for the cycle to play out. We never know when the scale will tip, and desire all the upside we can get while the sun shines, but are well prepared to take advantage should the tide go out.
2018 will certainly have more volatility than recent years past. We remain cautiously optimistic, with an understanding that variables well beyond our control can play a large role in temporary results. Most importantly, we remain confident in the market over the long term (5,10,15+ years) and the ability for Stocks / Bonds to keep producing solid long-term results that can meet planning objectives. 2016 and 2017 have offered solid returns in accounts that exceed our planning objectives. We look forward to 2018, ready to take advantage of opportunity should it arise, but hope to see continued gains and/or income that meet or exceed planning goals.
Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.