Friday, December 22, 2017

2018 Market Prediction

With the New Year rapidly approaching we are starting to see a flurry of market predictions for the 2018.  After extremely healthy returns across the global landscape in 2017 it is no coincidence that most prognosticators are bullish heading into next year.  As much fun as making predictions are, we also know that most are a waste of time and useless.  You only have to look at recent history of how awful these year end calls end up.  Nevertheless, most investors like seeing and hearing positive projections.  We prefer to gauge the current market temperature by analyzing various data points which help shape our bias in the short, intermediate, and longer term.  We study indicators including fundamentals, sentiment, volatility, and technicals.  One of the better blogs out there is from Urban Carmel at the Fat Pitch.  His recent blog takes a peek at 2018 and touches on a few of the data points we also watch.  I recommend reading the whole piece but I wanted to highlight one that stood out to us.  Most pundits will use past data to shape their future outlook.   However as we see from Urban's blog, prior years returns have no bearing on what stocks will return the following year.

"Data over the past 120 years shows that whatever happens in one year has very little impact on returns or probabilities the following year. If stocks gain over 20% this year, their return next year is not much different than if the market had fallen this year (right column). Moreover, the odds of stocks rising next year is the same regardless (second chart; both from Mark Hulbert)."

If we turn our attention to the monthly BAML global fund manager survey we can get a better idea of current sentiment and bias in the world markets.  Below is a recap of the December survey.

December FMS takeaways
  • Icarus loves Cash: Dec FMS shows investors raising cash to 4.7% from 4.4% despite surging credit & stock markets, paving way we think for more risk asset upside in Q1.  BofAML Bull & Bear indicator @ 6.2 is not excessively bullish, consistent with further Icarus trade upside. When asked when equity markets will peak, 25% of investors sayQ1’2018, 30% say Q2, 28% say H2.
  • Golditrumps: consensus still smitten by Goldilocks...54% expect “high growth, low inflation” in 2018. Almost 2/3 investors believe US tax reform will induce higher stocks& rates, but fiscal stimulus has coincided with lower, not higher profit expectations, and that will need to change given EPS leads relative performance of cyclicals by 3 month(Exhibit 10).
  • Pro-cyclical Consensus: Investors are long macro “boom”, short “bust”; long stocks,EU/Japan/EM stocks, financials (2nd largest ever), materials (highest since 2/2012) vs short government bonds, US stocks, healthcare & utilities. Pro-cyclical consensus entrenched by US tax reform across asset classes, bar, intriguingly, leading tech sector where allocations dropped to lowest since June 2014 (Exhibit 4).
  • FMS Crowded Trades: ...#1 long Bitcoin (32%), #2 long FAANG+BAT (29%), #3 short volatility (14%), while expectations for a “flatter yield curve” surged (highest in 18months), all trades vulnerable to higher inflation & aggressive ECB/BoJ Quantitative Tightening in 2018.
  • Contrarian Recession Trades: ...a recessionary bust even more contrarian than inflationary boom, lower rates more contrarian than higher rates, making short equities long bonds, short banks-long utilities, short EAFE-long US stocks the most contrarian trades of all heading into the new year.
We believe the strong returns of 2017 was due to multiple factors, however the growth of global economies and therefore earnings was the main driver of success.  This reveals itself in the survey as 54% of managers expect high growth and low inflation in 2018.  This is one of the main arguments for a bullish 2018.  A stable and growing economy coupled with US tax reform that could turbo charge earnings is what has us most excited for next year.  Before we get ahead of ourselves we need to recognize that some of this has been priced in the current markets.  As global markets sit at or near new highs it is interesting that the percentage of fund managers saying equities are overvalued is at multi-decade highs.  You would have to go back to the late 90's to find similar readings.  Meanwhile allocation to tech stocks falls to a 3 1/2 year low.  It seems managers are taking some profits after a huge run in tech related stocks.  Yet this could act as a contrarian buy signal for next year for this sector.  FMS cash rose to 4.7% reflecting a neutral stance among investors as cash levels are not near excessive overheated levels.  With cyrto-currencies the hot buzz word this holiday season it is no surprise that the most crowded trade is long Bitcoin.  With US tax reform passing Congress, two thirds of managers expect tax reform to result in higher bond yields and higher stocks while only 3% think it will lead to lower yields and stocks.  Lastly, allocation to US equities rises to net 15% underweight as Eurozone falls to net 45% overweight, but remains elevated versus history at 1.1 stdev above its long-term average.

In conclusion, we remain firmly in the secular bull market camp.  Yet, we also know from historical norms that the average intra-year drawdown is 14% in the S&P.  2017 was clearly an anomaly with regards to volatility as the biggest drawdown was a measly 2.9% and the last 5% drawdown occurred almost two years ago.  We expect a bigger drawdown at some point in 2018 coincided with a rise in volatility.  Regardless, we don't think it will derail the bull market and should be used as a buying opportunity as US equities remain underweight.  One of the biggest reasons we think predictions are so silly is the global markets are so dynamic as information changes rapidly.  At any given moment a new catalyst can reshape our thesis, however as we stand today the investing landscape looks promising into 2018 with the potential for an upside kicker in US markets based on tax reform.

We want to wish everyone a happy and safe holidays and look forward to what 2018 holds!

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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