2018: The View for U.S. Equities
2018: The View for U.S. Equities
Brian Foerster, CFA, Investment Strategist
As 2018 begins, how should investors view their allocation to equities?
So we've seen very strong returns this year from the U.S. equity market-- led by mega cap stocks and large cap stocks that have done well for the past six or seven years. And we've now had a sustained bull market going back to 2011 when we had the debt ceiling crisis. And in the years since we've seen a meaningful pickup in valuations, as represented by the S&P 500, whose price to earnings multiple today is about 24 times historical earnings, and about 18 times next year's 2018 earnings.
So the natural question is amongst investors, why would I get into the equity markets now? Or why would I add to my equity positions now when-- markets are trading at all-time highs, or near them? I would actually frame that a little bit differently.
First, using market multiples alone is a pretty horrible predictor of future market performance. But secondly, bull markets don't really die from old age. They typically come to an end because of one of four reasons. Either a big macro shock, the bursting of an unexpected bubble, slowing economic activity with recessionary or deflationary pressures, or conversely, from an overheating market leading to strong inflation and very high interest rates.
So those four scenarios really are not high on our list of risks right now. Although the definition of a shock is that it's unexpected. But nevertheless-- they're not part of our base case today. In fact, we think the better way to view this is looking specifically at the health of the equity markets today and the U.S. economy.
And when we do that a couple of things come to mind. First of all, in the U.S. equity market we've had an expansion going since 2009. And while that's a long expansion, it has been very shallow. Only about 17% total GDP growth. If you compare that to the average expansion where there's typically about 35% GDP growth, we're at about half of that today.
But more importantly, when you look at the end of Q3 earnings results you see very strong-- earnings growth, but also very strong top line revenue growth. And that's something that's been absent for quite some time. We have had the earnings growth during this expansion. But for most of that time you've actually seen flat or negative revenue growth. So where does that earnings growth come from? From cost cutting, layoffs, increased efficiencies and productivity, but not true organic growth. And now we're starting to see that.
So some might argue that we're now transitioning today in this expansion from a QE (or quantitative easing) part of the expansion to now a fundamentally driven part of the expansion. And that's good news. So areas that we think about today-- we look at areas like high-growth stocks, small caps-- and even value as potential places to invest.
Where are the most compelling investment opportunities?
So we do remain bullish heading into 2018. I would say, however, as a caveat to that that the bar is certainly higher. When you're in a price-to-earnings multiple range that I mentioned-- you're gonna have higher expectations. And when you disappoint there could be a big selloff in that name. So there could be a wider spread between winners and losers. So as we think about opportunities looking ahead, high-growth stocks had a very strong 2017, and we believe they will continue to do well in 2018.
The reason for that is many of these areas are in what we call secular bull markets. Meaning they don't need a strong economy to do well. And while we are seeing a modest pickup in GDP growth, areas like biotechnology, cloud software, e-commerce, hosted software, all are experiencing periods of robust growth. These are the engines of the technological revolution that are influencing not only the technology segment of the market, but also areas like health care, industrials, machinery. All areas that are benefitting from the technological revolution.
So we are big fans of high-growth stocks. But remember, there is a higher bar. These are names that must deliver on top-line revenue growth. They've done that in 2017. And we have very high expectations for 2018. Probably higher than what the market is pricing in. Secondly, when you think about small cap names we've gone through an extended period where small caps have lagged large caps very substantially, to the tune of about 2,300 basis points over the past five years.
Now, if you believe in the research that shows that over the long-term that small caps outperform large caps, you could just see the effective mean reversion over the next couple of years, where small caps again begin to resume leadership. Also, if we do get some of the policy implementation that we had hoped for at the end of last year, you could also see a boost to small cap names because they are more U.S.-centric.
So a tax cut, a corporate-- of the corporate rate tax cut could benefit small cap names more meaningfully than large caps. So you could see a boost from a cyclical perspective as well. Lastly, value. Value had a pretty rough 2017 compared to growth stocks. The spread between, say, small cap value and large cap growth was roughly 2,000 basis points. A tremendous spread.
A lot of these names have come down in valuation. And as investors look at areas for opportunity, maybe outside of growth, or necessarily small cap, but looking for true value, you could see a lot of mean reversion towards some of these value stocks, particularly in that smaller cap or midcap range.
So we're very bullish. We think there are a lot of opportunities. But potentially also headwinds for areas of the equity markets that have done well during the quantitative easing era, but maybe won't do so well during this more fundamentally driven part of the-- of this expansion.
For additional perspectives from Lord Abbett investment professionals, visit lordabbett.com.
U.S. equity markets, as referenced in opening segment, are represented by the S&P 500® Index, which is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries. Indexes are unmanaged, do not reflect deduction of fees and expenses and are not available for direct investment.
Gross domestic product data are from the U.S. Bureau of Labor Statistics.
References to investment opportunities refer to potential performance. Projections should not be considered a guarantee.
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