The State of the Markets

The famous investor Sir John Templeton once said, “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria,” a quote that links the market to cycles of human emotion. The questions I get all the time are, “Where are we in this bull market?” and “What should I do now?” Well, I would say we are in the place of optimism with some euphoria sprinkled in. Does that mean we are getting closer to the death of this bull? I don’t think so — even when the market drops several hundred points as it did this week in Tuesday’s trading session. But let’s review exactly what all the key variables look like right now.

Returns:
The S&P 500 Index has already returned 7.5% through the first four weeks of 2018. This represents the strongest start to a calendar year since 1987, and, relative to realized volatility, it is the best start since 1967. If you annualized the first four weeks of 2018 for the S&P 500, we’d finish the year up over 135%. That is not going to happen. That said, since 1929, whenever the S&P 500 Index has been positive for the month of January, returns have ended the calendar year in positive territory 85% of the time.

Tax reform:
The tax bill has the potential to be very stimulating to U.S. business, and that is why we’ve increased our estimates for U.S. markets at year end. Our 2018 target for gross domestic product (GDP) is now 2.9% for the U.S. and 2.3% for the developed markets. In addition, we’ve concurrently raised our domestic equity targets for year-end 2018. Here are the reasons for our updates:

  • The tax bill came faster than expected.
  • The tax bill was a larger total package than the markets had anticipated.
  • More front end was loaded into 2018/19.

At the end of 2017, we believed the market had not fully priced in these attributes, and that assumption has proven true so far in early 2018. The tax bill will be an interesting experiment, as we have never previously received this size of fiscal stimulus this late in an economic cycle. For 2018, original expectations were for a total tax stimulus of $100 billion, but the final bill now has the stimulus closer to $200 billion. Add to this change the repatriation of trapped overseas cash, 100% capex expensing on equipment, and finally a move from a worldwide to a territorial tax system and it is a big deal for this year. Altogether, we think this bill has put more gas on the equity market fire. Read the updated Outlook executive summary.

Volatility:
We are severely overdue for any type of correction (of 3%, 5%, or 10%) by any historical context. Last week we reached a new record for the longest streak without a 5% drawdown at over 400 days — breaking the prior record of 394 days set 22 years ago. Shockingly, a 60-day average of realized global equity volatility is close to dropping below fixed income volatility on the charts for the first time in history (a rather stunning fact when you think about it). I believe a correction would actually be healthy for the market, although there remains a lot of dry powder on the sidelines waiting for just such an event to enter on any dips. Therefore, if we get a correction, it may be shallow, and investors will need to act quickly to take advantage.

Economics:
Economic data remain strong. The U.S. Economic Surprise Index is at an all-time high, the ISM Manufacturing Index is in the 98th percentile since 1960, sentiment has swung from a 30-year low only 24 months ago (in January 2016) to a 15-year high (in January 2018), and forward-looking survey and sentiment data continue to tell an even better story than reported economic data.

Sectors:
For all of 2017, we continued to recommend sector overweights to financials, consumer discretionary, industrials, and healthcare. Three of those four outperformed the broad index for 2017, so they proved to be successful recommendations. We underweighted three sectors: utilities, energy, and consumer staples, and all three underperformed the broad index last year. To begin 2018, we keep the same sector weightings, as we believe — at least during the first part of the year — cyclicals will still outperform defensive areas.

Areas to watch:
We are keeping a keen eye on a number of variables. The recent rise in U.S. Treasury interest rates in a slow, gradual way has not yet disturbed the markets. The rapid rise of oil prices could create headwinds if that trend persists. And a close eye on the continued U.S. dollar depreciation all could pose threats/noise to the current rally. In addition, macro risk for 2018 remains omnipresent. By that, I mean geopolitical risk (North Korea, Middle East, Russia) and a more determined insular turn on global trade agreements (NAFTA, U.S./Korea trade agreement, China tariffs, and the like).

We are off to a very strong 2018 at levels that are really unprecedented. Markets are unpredictable, though. So for investors, and the financial professionals who serve them, it’s important to watch the signs on the horizon and stick to investment plans.
 

 
Risks

Forecasts are based on certain assumptions and on views of market and economic conditions which are subject to change.

Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. The prices of small cap company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions.

Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price.  Credit risk is the risk that an issuer will default on payments of interest and principal.  This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk.  All fixed income investments may be worth less than their original cost upon redemption or maturity.

Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate.

Definitions

Institute for Supply Management (ISM) Manufacturing Index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

General Disclosures

Wells Fargo Investment Institute, Inc. (WFII) is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Opinions represent WFII’s and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor.

By Darrell Cronk, CFA, Wells Fargo Investment Institute President, Wells Fargo Wealth and Investment Management Chief Investment Officer

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