2017 has been a fantastic year for the stock market and it is not to be confused with the fantastic years seen in 2009, 2010, 2012, 2013, 2014, and 2016. String those fantastic years together and you get a market (i.e. the S&P 500) that has risen nearly 300%, including flattish years in 2011 and 2015, from its financial-crisis low in March 2009.
Could 2018 be another fantastic year? Absolutely. Could it be a bad year? Yes. Could it be a flattish year? Uh-huh.
No one knows for sure what 2018 will produce for the stock market, because no one can accurately predict the future.
That caveat aside, 'tis the season for lots of predictions, and what many pundits are predicting for 2018 is a stock market that generates only modest price returns.
A Parallel View
The modest return projections are predicated in large part on the belief that easy central bank policies, which have suppressed long-term interest rates around the globe, have pulled forward returns and have driven multiple expansion, along with tax reform optimism, that has resulted in an overvalued market.
The latter has been open for debate.
Not everyone concurs with the view that the stock market is overvalued. That perspective is typically linked to the fact that interest rates remain historically low. Lately, it has gotten some added traction from the belief that a tax reform bill that cuts the corporate tax rate as low as 20% will pass soon.
The reduction in the effective corporate tax rate, according to some analysts, could add another 8-14% to S&P 500 earnings growth in 2018. Hence, there is a parallel view running today that the stock market is more reasonably priced than it appears if one accounts for another 11% boost (midpoint of estimated range) to S&P 500 earnings in 2018.
Doing the Math
According to FactSet, the bottom-up EPS estimate for 2018 is $146.04, which translates to a forward P/E multiple of 18.1x -- or a 27% premium to the 10-yr historical average of 14.2x.
An 11% earnings boost would put the EPS number closer to $162.00 and the forward P/E/ multiple at 16.3x, which is a 15% premium to the 10-year average.
The stock market's concerns about overvaluation, then, have been mitigated by the persistence of low interest rates. The 2.38% yield on the benchmark 10-yr note is 10 basis points lower than where it started the year and 136 basis points below the 20-year average of 3.74%.
Market bulls have a basis to rationalize further upside for the stock market for a couple of mathematically-based reasons: (1) interest rates are still historically low and (2) they know this market has already been tolerant of an 18x P/E multiple with rates remaining historically low.
If the 2018 earnings boost from tax reform comes as expected, an 18x multiple would leave the S&P 500 at 2915, or approximately 10% above its current level.
The ability to get there, though, will ultimately rest on interest rates remaining low, all else equal.
The key question is, will all else remain equal? Our unequivocal answer is no.
There will be changes. The relevant matter for the stock market is the degree to which things change with respect to interest rates, inflation, and earnings.
That triumvirate forms the fundamental foundation for moves in the stock market and they react to changes in the economy, which are driven by fiscal and monetary policy (both of which are in the process of changing).
When interest rates and inflation are low, and earnings growth is strong, good things often happen for the stock market.
When interest rates and inflation are high (or rising), and earnings growth slows, less good things -- and sometimes bad things -- happen for the stock market.
There is an assumption that interest rates will be moving up in 2018 based on projections from the Federal Reserve and the faster growth that is forecast to flow from individual and corporate tax cuts.
That assumption aside, the benchmark rate has remained low, helped in part by foreign buyers seeking higher yields. The 10-yr yield might be low on an historical basis, yet it is relatively high compared to the 0.04% yield on the 10-yr Japanese bond and the 0.35% yield on the 10-yr German bund.
The fundamental fact of the matter, though, is that inflation has remained low and that has helped hold down the bond risk premium.
That consideration exposes the importance of inflation trends since higher inflation should lead to higher interest rates and a higher bond risk premium.
Accordingly, rising inflation is a key risk factor for the market in 2018. If it were to materialize, long-term rates theoretically should move higher, which would provided added competition for stocks that have been riding high on the persistence of low interest rates.
The wrinkle -- or wrinkles -- in that assessment are the ECB and the Bank of Japan. If they hold fast to their easy monetary policies, the interest-rate differential trade could offset an inflation trade that might otherwise on its own upset the bullish bias of the stock market.
Therefore, one can ascribe important interest rate risk to hawkish-minded changes in the monetary policies of the ECB and/or the Bank of Japan. If those changes happened and were paired with rising inflation in the U.S., it would be a double whammy for the Treasury market that would concurrently hit the stock market.
Some Mighty Thoughts
There are always a lot of "ifs" attached to any stock market outlook. That's because the possibilities are endless in an unpredictable world.
If the stock market got hung up on all of the uncertainty that was part of 2017, we might be writing today that it had a very bad year. As it so happens, the stock market climbed the proverbial wall of worry and quickly regrouped on any slide, supported by fundamental underpinnings that included low interest rates, low inflation, and solid earnings growth.
Everything else was just noise, and it can be deemed such because none of it upended those fundamental support structures.
Might it be different in 2018, which promises to generate another dose of political uncertainty as Congress wrestles with working out a budget, raising the debt ceiling, and the mid-term elections; and Special Counsel Mueller continues his investigation into Russia's interference with the presidential election?
Might it be different as China works to curtail speculative excesses in its financial system, Kim Jong-un continues to push North Korea's nuclear capabilities, or as Saudi Arabia aims to increase its influence over Middle Eastern affairs?
Might it be different if the "FAANG" stocks -- Facebook, Apple, Amazon.com, Netflix, and Google (aka Alphabet) -- underperform?
It is possible things are different, but for practical investing purposes, interest rates, inflation, and earnings are going to be the difference makers that determine whether 2018 is a fantastic year, a bad year, or a flattish year.
What It All Means
From our vantage point, we see a market that gets riled up more by minor setbacks than it does by further gains.
We think that's because the stock market hasn't had a meaningful setback in a long time; therefore, when a pullback does happen, the anxiety about it being the start of something big is more palpable than the enthusiasm is for additional gains.
Our viewpoint is admittedly refutable based on the low reading for the CBOE Volatility Index, which doesn't connote a lot of concern about downside risk in the near term. Nevertheless, there is definitely a lot of hand-wringing when the technology sector, for instance, sees a 1% decline or when the S&P 500 starts strong and finishes on its lows for the day.
Neither of those things has happened a lot in 2017, which has produced a succession of record highs for the major indices.
Still, we would contend that the angst associated with those developments, when they happen, is a reflection of tacit concerns about valuation and this bull market being long in the tooth.
As a reminder, bull markets don't just die of old age. Bull markets typically die when a recession arrives or the fear of a recession takes over.
A recession fear is not prominent at this juncture, which is why the desire to buy on dips still outweighs the inclination to sell into strength.
Be that as it may, there are a lot of stocks that have made big moves and a lot of passively-managed funds that have done the same. Might it be time to do some selling? The answer will boil down to individual risk tolerances and a bid to maintain prescribed weightings in the equity portion of a diversified portfolio.
The stock market might not be overvalued in a relative sense, yet bear in mind that it is being propped up in an absolute sense by the persistence of low interest rates.
If, and when, those interest rates rise, total return prospects will diminish -- and they could diminish quickly if interest rates move up at a rapid pace and/or the crowd-funded momentum of this bull market gets pulled.
The stock market may not have a down year in 2018, yet it may find it difficult to have another fantastic year like it did in 2017 if everything doesn't go just right with low interest rates, low inflation, and strong earnings growth.