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Market View

In 2017, equity markets once again debunked the “low-return environment” narrative forecast by many experts. How accurate was our outlook?

(In last week's Market View, we noted that fixed-income markets in 2017 did not follow the path that many had predicted at the end of 2016. This week, we assess the accuracy of forecasts for the equity markets in 2017.)

The length of the current equity bull market (six-plus years) and the even longer U.S. economic expansion (eight years) has humbled many Wall Street strategists and prognosticators. In our opinion, one of the main reasons for the overall failure to forecast correctly was a disbelief that companies could experience strong earnings growth and thus compelling stock returns in a slow-growth economic environment and at a time when macro risks were thought to be daunting. The narrative, after all, was supposed to be “low rate, low growth, low return” for the foreseeable future as the result of debt, demographics, and de-risking in the developed world. Yet we believe we have moved from a liquidity-fueled stage of this bull market to a more earnings-driven stage, and the likelihood of the bull market’s continuation has strengthened, defying this narrative.

Interestingly, in reviewing prominent Wall Street prognostications going back to 2010, from many renowned market participants, we note that each year has been framed in a strikingly similar way: 6–8% forecasted equity-market returns, hedged with a host of risks that could derail that potential, and muted returns across fixed-income asset classes. The phrase low-return environment has become ubiquitous, derived from building-block math that insists that below-trend economic growth equals paltry investment returns.

Moreover, in recent years, as traditional market valuations have crept higher, the added wrinkle to the mantra of low expectations is that we’re overdue for a pullback and that a correction is coming. Of course, there have been multiple corrections/pullbacks along the way, ranging from 5–13%—in fact, there was at least one per year from 2011–16.

We will stipulate that there is a 100% chance of a correction coming again at some point in the future. We also believe that the bull market will end someday, and, of course, we will experience another recession at some point.

Nevertheless, despite the fears of a rally gone too long, there is little fundamental evidence to suggest that risk assets are poised to collapse in 2018, very much unlike 2000, for example, when a flimsy tech sector was trading at extreme valuations, or in 2008–09, when the roots of the housing market were exposed as fraudulent throughout the global financial system.

While it seems most investors and strategists are concerned with assessing how to limit absolute risk exposure, we would argue there is equal danger in failing to account for upside-risk in asset allocations.

For example, what if we are only halfway through the greatest equity bull market of our lifetimes?  Is there a true historical basis for comparison to the soft landing the U.S. Federal Reserve (Fed) engineered after the financial crisis of 2008–09 with the most aggressive quantitative-easing program in U.S. history? What if interest rates continue to stay very low and stable while inflation remains at a healthy, yet low level? Are we only now just beginning to see the organic growth from corporations that is a hallmark of earlier stages of the business cycle? What if non-U.S. equities are only now just beginning their own multiyear bull market, buoyed by a long-delayed economic expansion in Europe and developed Asia? What if China doesn’t see its gross domestic product (GDP) growth crash but instead surprises on the upside? What if we are seeing only now the true hyper-growth phase of secular bull markets driven by the technological revolution? In the charts below, there is in fact evidence that we could be seeing some of this acceleration in corporate fundamentals around the world.


Chart 1. We Could Be Seeing Synchronized Earnings Acceleration Around the World
Trailing 12-month year-over-year earnings growth for indicated indexes

Source: Strategas.
Past performance is no guarantee of future results. Performance during other time periods may have been different or negative. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment. For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment.


These are risks of the other sort, whereby investors could miss important years of market gains because of a myopic fear of short-term drawdowns.

Some or all of the hypothetical questions above could, we grant, be greeted with a resounding “no” at some point in 2018, 2019, or beyond. However, there is ample historical evidence (such as examining corporate income statements and balance sheets) to suggest that the “low-return” thesis may continue to be off the mark, and that fears of a surging interest-rate environment largely are based on anchoring bias to history rather than actual economic data.

The year 2017 was a banner year for risk assets in most global capital markets, despite a tumultuous geopolitical backdrop, in large part thanks to strengthening corporate earnings and moderately higher economic growth. With persistently low interest rates, a continued monetary policy tilt toward accommodation, and low current risks of a global recession, we would argue there is plenty of reason to continue allocating to risk assets.

Here is a review of what experts got right and wrong in 2017, and what could persist into 2018: 

“We’re expecting 6–8% equity market returns in the coming year.”
—Nearly every Wall Street strategist, every January

Heading into 2017, there was an uncharacteristic amount of general optimism regarding equity markets, at least compared to the prior nine calendar years. That optimism centered around the potential impact of a one-party government that was determined to pass pro-business, anti-regulation legislation and potentially even pass an aggressive infrastructure stimulus that could reinvigorate many segments of the U.S. economy. Yet despite this general outlook, the stated market return expectations from strategists were still perplexingly modest. Note the bullishness of the title of last December’s feature in Barron’s (“Outlook 2017: This Market Has Legs”) and the underlying return expectations (“about 5%”):

“If the Republicans don’t make progress with their proposed reforms by mid-2017, say the strategists, the market will correct. For the moment, however, there is hope—and plenty of it. Collectively, the strategists’ mean expectation for the Standard & Poor’s 500 puts the index at 2380 by the end of next year, up about 5% from last week’s 2258. In years past, top forecasters often called for a market gain of up to 10%, but the second-longest bull market ever is getting on in years, and besides, it has rallied furiously in the past five weeks.”

The danger of listening to the consensus is that it is so well anchored to a safe average, and the reality of the market rarely abides to the average. At Lord Abbett, we too were optimistic about equities, and highlighted, in particular, the appeal of secular-growth segments of the U.S. economy, while maintaining a cautiously optimistic view around the immediate impacts of fiscal stimulus on U.S. GDP growth.              

As we wrote in our outlook for 2017:

“Interestingly, while the economic landscape has changed due to political change, our outlook for 2017 is not significantly different from that of 2016, at least from an equity perspective. We still think exposure to high-growth stocks will be important in the coming years for investors who need to meet long-term portfolio objectives. While we believe economic growth could accelerate with infrastructure and tax policies, it likely will still remain below trend for some time to come…”

Nevertheless, it is fair to say that we, like the consensus, expected more legislation to pass in the earlier part of the year with a one-party government in place, and, as a result, we expected smaller-cap and more cyclical companies to benefit most from that stimulus. As the more contentious reality set in, these segments pulled back and we saw a reversion in the markets toward segments that had done well during the quantitative-easing period of 2010–16—namely, select high-growth companies and more bond-like equities with yield and stability, such as consumer staples and utilities.

Which brings us to the last prediction we had at the outset of 2017: it was our expectation that we would see a meaningful reversal of fortunes. While broad market averages surged higher in 2017, there was segmentation across sectors and industries. One way to view the 11 equity sectors is to group them into three categories:

1) “FEMI” (financials, energy, materials, and industrials)—These four sectors averaged a positive 13% return in 2017, though they had a fairly wild ride. In addition, they were the sectors that rallied most significantly in the immediate aftermath of the election. In this space last year, we characterized the rally as part of a “psychological recalibration” in the market of these areas of the U.S. economy that largely had been in secular stagnation for the prior eight years. These were the sectors expected to benefit most from a policy regime change. Then came the failure of the first healthcare reform bill to pass in late March, and all four sectors sold off sharply, reflecting the diminished expectations for the entire policy agenda in 2017. As the year closed and the tax reform bill passed and became law, these sectors have since rallied.

2) “RUST” (REITs, utilities, staples, and telecoms)—Yes, the acronym is intended to reflect the lack of appeal in these sectors, not because they can never deliver strong investment returns but, more to the point, that these sectors did just that for six-plus years with little to negative underlying organic growth. The appeal of these sectors was quite simply their stability and income generation. In a period when investors frequently were risk averse, but were not willing to buy traditional haven assets because they too represented principle risk, many used high-dividend, low-volatility equities as proxies for the bond market.

3) Secular growth (information technology, health care, consumer discretionary)—This is a generalized representation of the fastest growing and most insulated sectors from broad economic growth, as it is home to many high-growth industries, including biotechnology, cloud computing, artificial intelligence, the Internet of things, and the continued automation of everyday life (e-commerce, robotics, etc.). In recent years, these sectors have been dominated by a handful of mega-cap dominant leaders, such as the FANG [Facebook, Amazon, Netflix, Google] trade in 2015 and the offshoots of that acronym this year (FAANG [Apple included], FAAMG [Microsoft included]). As we look at revenue growth rates and market-share changes, we believe the growth going forward could come much more from smaller capitalization names in some of these areas.

Equity Outlook
In summing up our views, the first thing we would say is that it is actually advantageous not to listen to specific annual market forecasts that attempt to predict a return or landing point for market averages. As we mentioned earlier, Wall Street forecasts have been shown not only to be wildly off the mark on an annual basis but also there actually is robust evidence that such forecasts actively detract value from pure random predictions. For example, in 2008, consensus finally deviated from the 6–8% range and rose to 11.1% expected market returns. That was the year the S&P 500® Index fell 38%. So, the one thing we will not do here is attempt to predict an exact return for an exact period. Nor should anyone else.

That said, as you extend the horizon and focus on data rather than feel or hunches, the reality of the bull market’s merits begin to emerge, and as we assess portfolio allocations, we believe there is a clear need for equity exposure in years to come. On the one hand, as economic growth continues to plod along amid record deficits, continued Fed accommodation, and muted inflation, we are still a mature economy struggling to reflate itself from the aftermath of 2008–09, with remaining slack and capacity to spare. On the other hand, the recently passed tax law is consequential for the U.S. economy, primarily on the corporate side, and will have a meaningful effect on corporate profits derived from U.S. revenues. Logic and math would suggest that should be good for cyclicals and small-cap equities, particularly relative to bond proxy equities (such as “RUST”) and mature mega-caps. We fully realize by saying this we are doubling down on last year’s forecasts, which makes sense, to us, as we now have evidence of the expected legislative stimulus from last year that should flow through to financial statements in 2018.

Perhaps most important, however, is that we believe that investors should consider “owning” innovation in at least a part of their equity portfolios. Sectors such as biotechnology, which is still in its infancy of transforming medicine, cloud computing, artificial intelligence, and the continued surge of e-commerce are all areas of the economy that may be revenue-growth leaders for the next decade-plus. Not owning these areas, due simply to trying to time the next market correction or the next worry around the corner, most likely will be the number-one detractor from investors’ portfolios, while they consider their long-term goals.


Table 1. Investors Should Consider “Owning” Innovation, Such as Biotechnology Stocks
Historical sales growth last 12 months (LTM) and three-year periods ended December 29, 2017 

Source: Russell.
Past performance is no guarantee of future results. Performance during other time periods may have been different or negative. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment. For illustrative purposes only and does not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment.


Summary—Our Five Key Forecasts
In short, we are not pounding the table that we definitely will have a robust year; we have, in fact, ignored the macro risks that are omnipresent, the political anxiety we’ll see in 2018 as the midterm elections approach, and the potential for earnings to disappoint in the near term. Rather, we are arguing that there is sound fundamental- and data-driven support for the equity markets and valuations, and that the myopic views of many Wall Street forecasts can drive investors in precisely the wrong direction. Owning equities for the long run is, we believe, essential to investing success, and in any era, there are always plenty of reasons to convince oneself not to own stocks. However, missing bull markets when they come along can be even more damaging to meeting long-term goals than experiencing drawdowns from bear markets. In that light, here are our five key themes for 2018:

  • Fundamentals suggest potential for continued upside surprises in terms of U.S. equity-market returns, driven by earnings growth and continued multiple expansion in cyclical and secular growth segments of the economy.
  • There likely will be a continuing narrowing of the output gap to where it turns positive, which at full employment could finally lead to some inflation and higher interest rates, which, at these low levels, would not yet be headwinds for equities.
  • We may see a long-awaited return to leadership of cyclicals and small-cap equities in the United States as a result of increased GDP growth and fiscal stimulus.
  • Election-year animosity, with heightened rhetoric in political campaigns, is likely to contribute to market volatility as November approaches.
  • Earlier-stage economic expansion in Europe may drive further multiple expansion, so long as earnings acceleration continues and the ultra-accommodative policies are not unwound too quickly. 



  Market View
  U.S. Market Monitor


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