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Typically this time of year, we start to see the contrarians and the “doom and gloomers” come out of the woodwork. There are usually a number of articles with negative theses about why the market will crash in the upcoming year. There are usually more negative articles this time of year than snow in the Great Lakes area. The negative articles could stem from various motivations, which could be political or just attention-getting. I do my best to explain what is likely to happen without any ulterior motives. Well, I’ve poured over a lot of data and don’t see a recession or bear market for stocks in 2018. The data that I analyzed suggests we are likely to see a net gain in the stock market in 2018 along with continued economic growth.
Of course, I do acknowledge that we could see a correction or selloff of about 10% at any time. This could be triggered by any significant unexpected event: a large scale terrorist attack, nuclear attack, large scale profit taking by many large institutional investors, worse than expected earnings reports, significant slowdown in home sales or other economic indicators, or another significant negative unexpected event such as a large natural disaster.
Although any of these things can happen, I wouldn’t put a high probability on them actually happening in 2018. Economic-wise the indicators look positive, which I expect to spill over into 2018. So if something significantly negative does occur in 2018 to trigger a market correction, it would probably be a non-economic event.
We shouldn’t worry so much about a 10% correction anyway. The market always recovers from these pullbacks. The bigger danger for the market would be the threat of a recession, which would likely trigger a larger and longer sell-off or bear market. Based on the data that I’ve compiled, we are not likely to experience a recession in 2018.
Key Recession Indicator
One of the most reliable indicators for an impending recession is an inversion of the yield curve. That occurs when short-term yields become larger than longer-term yields. This typically happens after a series of interest rate increases from the Federal Reserve. The yield curve inverted before the last seven recessions going back to the 1960s.
The chart above displays the current yield curve. It is upwardly sloping and normal. The danger for the stock market will occur when the yield curve flattens out and then becomes inverted or downward sloping. The yield curve becomes inverted when interest rates become unattractively high for lending purposes after a series of interest rate increases.
Although we had a few interest rate increases, we are starting from historically low interest rates. Therefore, this interest rate increase cycle is likely to last much longer than past cycles. The Federal Reserve is forecasting to raise rates about three times in 2018.
The stock market peak typically occurs around the time of the inversion or a few months after the inversion. The actual recession typically occurs 12 to 18 months after the inversion. I would expect the market to sell-off or get volatile when the yield curve inverts. Large institutional investors are likely to react to an inverted yield curve by selling shares and shorting the market.
I expect the selling to occur quickly the next time the yield curve inverts due to the prominence of high frequency traders accounting for about 70% of the trading volume in the United States. The HFT traders will probably have programs to trigger selling and shorting when the yield curve inverts as they anticipate an impending recession. This would cause a sharp drop in stock prices.
With the Federal Funds rate at just 1.5%, I don’t think that the next three rate increases that are expected to occur in 2018 will lead to an inverted yield curve. By the end of 2018, the Federal Funds rate will be about 2.25%, assuming three rate increases of 0.25% each. The credit markets are likely to remain conducive for lending and healthy for business growth at this rate.
Tax Reform to Stimulate the Stock Market and the Economy
The recent tax bill that was passed is likely to stimulate the stock market and the economy in 2018. Lowering the corporate tax rate from 35% to 21%, will benefit many companies. With the average effective tax rate at over 27%, many companies will benefit from an earnings boost as a result of the tax cut.
I realize that some companies pay less than the current proposed rate. However, there are many that pay much more than 21% and some pay more than 35%. UBS Group (UBS) estimates that the tax reform will result in a 9.1% increase for S&P 500 (SPY) earnings. The increase in earnings is likely to translate into higher stock prices, since stocks tend to rise as earnings increase.
The lower tax rates for individuals will put more money into the hands of consumers. This money is likely to make its way into the economy as it is spent. This will help accelerate the rate of economic growth. The Tax Foundation estimates that the tax cuts will result in the GDP increasing by 0.44% over the previous estimates in 2018. GDP growth is expected to grow 2.6% in 2018 over 2017’s 2.2% growth.
The repatriation of money held overseas is another catalyst for the stock market and investors. Companies can use this money for anything: expanding businesses, acquisitions, pay increases, bonuses, dividends, and stock buybacks. If history is any guide, the tax holiday plan in 2004 led companies to use repatriated money for improving balance sheets and rewarding shareholders with dividends and stock repurchases – all good for investments.
The November jobs report showed that non-farm payroll jobs increased by 228,000. This demonstrates healthy growth since the economy needs jobs to grow by 150,000 per month for continued expansion. The unemployment rate is low as it stands at 4.1%. However, there is room for improvement since there are 4.8 million ‘under-employed’ people who are working part-time who would prefer to work full-time. The good news is that the amount of under-employed is showing improvement as the number decreased by 858,000 through 2017.
Average hourly earnings increased 2.5% in 2017. This increase along with employment growth is providing consumers with more spending money which is likely to benefit the economy in 2018 as the positive trend continues. The tax reform will also put more money into the hands of consumers and encourage companies to give pay raises.
Another driving factor for the economy is the health of the housing market. New home sales in November increased 17.5% over October and 26.6% over November 2016. Existing home sales increased 5.6%, which was the strongest pace in 11 years.
Strength in the housing market shows that consumers are able to make large purchases. Housing market growth is also important because it leads to other major purchases such as appliances, furniture, and other home-improvement spending. This is likely to spill over into 2018 as these homeowners continue to spend money on their homes to customize them to fit their needs/wants.
The latest Manufacturing ISM report showed that the overall economy grew for the 102nd consecutive month. The PMI increased to 58.2% in November as compared to 53.2% from November 2016. Fourteen out of 18 manufacturing industries reported growth in November. New orders are growing and customer inventories are too low according to the report. This indicates that manufacturing activity is likely to continue growing in 2018. Customers will need to increase inventory, which will lead to further increases in orders.
Non-manufacturing economic activity also increased in November. This marked the 95th consecutive month of growth for non-manufacturing businesses. All of the non-manufacturing industries reported growth except for the Agriculture, Forestry, Fishing & Hunting industry. The growth industries include: retail, finance, real estate, health care, and others.
It is positive to see growth from both the manufacturing and non-manufacturing sides of the economy. This demonstrates that economic growth is broad across multiple industries. The tax reform is likely to help this economic growth continue in 2018. Businesses and consumers will have more money to spend for further economic growth.
FactSet is forecasting earnings growth of 11.8% for the S&P 500 in 2018. This is higher than the expected earnings growth of 9.6% for 2017. It is also the first time we’ll see double-digit earnings growth since 2011. This growth will help keep stocks moving higher in 2018. Even if valuations stay the same, the market could easily increase by double-digits in 2018 as stocks are typically driven by earnings growth.
What Investors Should Expect in 2018
We are already experiencing growth in key markets in both manufacturing and non-manufacturing industries. The real estate market growth is a key factor that is likely to lead to further growth for the economy in 2018. Consumers are likely to make additional purchases of big-ticket items such as appliances, furniture, and renovations related to their homes. New home sales are likely to remain strong since inventory of existing homes for sale has been low.
Tax reform will help accelerate the growth that is underway as consumers and businesses have more money to spend. Expect to see further increases in wages, more under-employed people becoming fully- employed, and continued growth in the stock market.
I wouldn’t be surprised to see a correction or pullback of 10% this year on an unexpected event. We haven’t experienced a correction of 10% or more since 2015. However, I also wouldn’t be surprised to see only minor pullbacks of 5% or less if nothing significantly negative occurs in 2018.
The major key takeaway is that a full blown bear market or recession is not likely to occur in 2018. There is a lot of positive momentum in the economy right now and the tax reform will help keep that going. I expect companies to use the extra money for a variety of things including: dividends, share repurchases, acquisitions, paying down debt, wage increases, bonuses, business expansion, etc.
I expect the S&P 500 to gain at least 12% in 2018, driven by earnings growth. However, I wouldn’t be surprised to see a higher gain like the 20% gain we saw in 2017. That could depend on whether we experience a correction in 2018 along with a follow-up recovery period. It will also depend on how investors will react to further interest rate increases. Overall, expect further growth for the stock market and the economy in 2018.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The article is for informational purposes only (not a solicitation to buy or sell stocks). I am not a registered investment advisor. Investors should do their own research or consult a financial advisor to determine what investments are appropriate for their individual situation. This article expresses my opinions and I cannot guarantee that the information/results will be accurate.