Wednesday, December 27, 2017

Will 2018 Be a Repeat of 2017?

Bob Pisani of CNBC reports, Could 2018 surprise with the same outsized gains as 2017?:
Will 2018 be a more "normal" year? 2017 was a year of surprises, but for 2018, not surprisingly, things are expected to be more, well, normal.

Which is why you should be suspicious.

It's true — by almost all measures, 2017 was one of the most extraordinary years in the history of the stock market. Investors saw:
  1. Extraordinary returns far above the norm. The S&P 500 is up nearly 20 percent this year, far above the roughly 8 percent average yearly gains since 1945.
  2. Extraordinary new highs. We hit 62 daily all-time highs this year, far above the average of 29 that have occurred in years when at least one new high was reached, according to CFRA.
  3. Extraordinarily low volatility. The S&P moved 1 percent or more on only eight trading days this year; the average since 1945 was 50 days.
  4. Extraordinary sector dispersion. The top-performing sector — technology, up 38 percent —outperformed the worst-performing sectors (energy and telecom, down about 5 percent) by more than 43 percentage points.
What does all this mean? The stock market is a numbers game with a long track record. When you get numbers that are way out of the ordinary, it's logical to believe in mean reversion, that it is highly unlikely that returns or volatility will come anywhere near 2017.

That is exactly veteran market watcher Sam Stovall's advice to his clients. Stovall is chief equity strategist at CFRA, and in a note to clients advised that investors "would be better off anticipating an increase in volatility, a reduction in new highs, as well as a below-average price gain for the '500' in the year ahead."

Getting these extraordinary numbers tends to pull forward stock market performance. In years with above-average new highs and below-average volatility (exactly what we had in 2017), the S&P rose the following year only 55 percent of the time, with an average gain of only 3.1 percent, Stovall noted.

In years where the "dispersion" between the best- and worst-performing sectors was high (also what we saw in 2017), the S&P 500 was also up only 57 percent of the time in the following year, with an average gain of only 1.9 percent.

Stovall's conclusion: "As a result, one could say that in 2018 investors should expect more for less — more volatility for less return."

Get it? "Less surprise" is a big theme for 2018. Jim Paulsen, chief investment strategist for Leuthold Group, has noted that a good part of the stock markets' gain has been related to the string of strong economic numbers that we have seen recently: He notes that the U.S. economic surprise index rose to a 6-year high last week.

"Even if the recovery remains healthy in 2018, it can't continue to surprise," Paulsen says.

But why can't it continue to surprise? Peter Tchir, macro strategist for Academy Securities, is not so impressed with the "reversion to the mean" story.

Tchir notes that the global economic expansion continues, that earnings remain at record highs, and the tax cuts are pushing those numbers up: "It doesn't feel like the tax cut is being fully priced in, and there's no reason corporate America can't keep issuing debt and buying back stock. I'm not sure we can't have more of the same."

And absent some outside shock, why can't volatility remain low, he asks. "With ETFs, people have less need to chase daily trading, and I think that's a good part of the reason why we have seen reduced volatility."

Bottom line: Reversion to the mean does eventually happen, but we are in very unusual times.
These are unusual times. In my last comment on the Santa rally, I discussed why even though the market is overbought on a weekly basis, this isn't necessarily a bad thing and if the rally continues early into the new year, it could be a harbinger of another good year.

But I also cautioned my readers that as the market keeps "melting up", so do downside risks. The silence of the VIX and the silence of the bears are deafening, but risk assets cannot decouple from the economy forever, at one point reality will settle in and it will be a long and brutal winter.

Of course, traders know this but they also know there is a lot of liquidity out there no thanks to central banks trying to stoke inflation expectations higher through creeping market euphoria.

This is why even though it seemed like it's as good as it gets for stocks at the end of Q1, they kept soaring higher, making new record highs.

Nowadays, everyone is talking about the best of all worlds for stocks, meaning low inflation, solid global economic growth, good earnings, all helping to boost stock markets around the world higher.

Interestingly, Anastasios Avgeriou, Chief Equity Strategist at BCA Research., posted this chart on LinkedIn showing the 2017 asset performance in US dollars (as of last week):


I would have liked to have seen this in local currency terms too as the US dollar (UUP) didn't have a good year. Also worth noting, in US dollars, Canadian equities are up 12.6% and Mexico 12% year-to-date. These two countries didn't perform as well as the rest because of energy and onging NAFTA negotiations.

The key message in 2017, risk assets were all the rage as investors chased yield. This is why you saw emerging markets, Japanese and European stocks do very well this year.

Should we expect more of the same in 2018? I wouldn't bet on it but from Bob Pisani's article above, one thing I want to stress is when you see technology shares (XLK) up close to 40% in one year, that's typically a bad omen for the following year (some tech ETFs performed a lot better than the average in 2017).

Why? Because when portfolio managers all turn to large cap technology shares, it's typically a defensive play as they're worried about what lies ahead. So, buying more FANG stocks worked well in 2017 but it might not work as well next year.

One area of tech which I'm watching closely is semiconductor shares (SMH) which have been a little weak going into year-end:


The other sectors I'm watching closely are Metals & Mining (XME) and energy (XLE) which have rallied going into year-end (the former a lot more than the latter):



I think this is normal sector rotation but the reflationistas are going to argue global economic growth is a lot stronger than we think and now is the time to load up on commodities and these cyclical sectors.

I remain highly skeptical, trade these sectors but don't expect a major uptrend and if something goes wrong, they will be sold hard.

Below, closely followed strategist Jeff Saut told CNBC on Wednesday that he expects the stock market to grind even higher in the new year.

"I would expect 2018 to be an almost repeat of 2017," said Saut, chief investment strategist at Raymond James. "People are still way underinvested. Earnings are starting to come in better than expected. And with the tax reform, and especially the corporate tax cuts, I think earnings are going to continue to surprise on the upside."

Maybe but if stocks keep melting up, you'd better hedge your downside risk by buying more US long bonds (TLT)  because as I keep warning you, nothing goes up forever, and when the music stops, all risk assets including stocks are going to get clobbered.

So, if I was betting on it, I'd bet 2018 won't be a repeat of 2017. Hedge accordingly and don't buy the nonsense all these strategists are peddling, namely, "JUST BUY MOAR STAWKS!" and bonds are a terrible investment. You won't get rich off bonds but you will protect your portfolio from being obliterated.

I'll be back next week, wish you all a Happy and Healthy New Year and I'd particularly like to thank all of you who took the time to contribute to this blog in 2017, I truly appreciate it.

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