Which segments of the market hold the most promise in the coming year? Here are the ones to watch.

In Brief

• What themes should investors be following in key global equity segments as 2018 begins?
• Growth: For U.S. growth stocks, we think e-commerce and biotechnology are among the best-positioned groups. Growth opportunities in other geographies include housing and finance sectors in India and Malaysia, and European luxury goods.
• Small and midcaps: We believe U.S. small- and mid-cap equities are much more attractively valued than mega-caps. We are very bullish on international small-cap equities. [Note that non-U.S. equities carry greater investment risks.]
• Value: Value stocks lagged other styles in 2017. In 2018, we would argue that it is critical to be selective and not view names in the various value-stock indexes as all alike.
• The key takeaway: The bar for stocks is higher after 2017’s strong performance. In 2018, we believe it will be necessary to identify companies with fundamental strength worthy of their valuations.

In 2013, we authored a white paper examining the “twilight of the dystopians” (“Doom and Gloom Leave the Room,” March 27, 2013) in which we noted that extremely bearish forecasts for equities became less and less relevant, as the financial crisis of 2008–09 recedes from view. That essay, as it turns out, was spot on in terms of deeming equity markets as highly attractive, while also setting the record straight on perma-bear prognosticators who were still advising wary investors to get out of stocks completely. These were the same “broken clock” bears (i.e., right twice a day) who finally hit paydirt in 2008, when their forecasts of doom collided with a true crisis that briefly made many of them celebrity financial forecasters.

Our central thesis was that the continued arguments of these doomsdayers were flawed because they considered the economic imbalances in a vacuum—that is, failing to anticpate the deployment of countercyclical policies, such as quantitative easing and bank-recapitalization programs to offset the imbalances. Further, many members of the “doom and gloom” set were simply wrong about the consequences of massive stimulus and and their forecasts of hyperinflation. And so, while this myopic fringe has been resoundingly proved wrong since then, risk aversion still persists among many investors when it comes to equities. 

Today, the concern among investors—much more legitimate, we think, in this instance—is that broad market valuations are too high. We would counter this by asking, relative to what? If large corporations were still in the throes of an earnings recession, such as the one we saw in 2014–15; or if the overall economy appeared headed toward a recession; or if the yield on the 10-year U.S. Treasury note was somewhere in the neighborhood of 5–6%—then certainly the current forward price-to-earnings (P/E) ratio of 18x on the S&P 500^® Index would appear to be cause for concern. Instead, however, equity markets have the backdrop of rising corporate profits, a persistently low 10-year Treasury yield, incrementally positive U.S. gross domestic product (GDP) growth, and, for the first time in nearly a decade, strengthening top-line revenue growth in a number of sectors.

Despite this strengthening data, the chief argument today among doubters is that the bull market either has simply lasted too long and is “due” to end or that nominal valuations are too high. On the first point, yes, we have seen a lengthy economic expansion since 2009 and a lengthy bull market that began in earnest in late 2012, following the European debt crisis. With respect to the economic expansion, while it has lasted for more than eight years, it has been an incredibly shallow one, with just 18% total cumulative GDP growth (less than 2% a year, on average) over that time span, according to data from the U.S. Bureau of Labor Statistics. When looking back at expansions over the past century, average total GDP growth has been on the order of 35% per expansion, making the current one potentially still in its mid-innings. 

With respect to the current bull market, the only other precedent we would cite consists of two noteworthy examples, drawing on historical data from Bloomberg. The first one is 1936–56, a 20-year period following the Great Depression, when the 10-year Treasury yield remained below 3%. Once the United States entered World War II, the stock market began a 16-year period in which the equity market returned 18.8% per year, without rising rates or much inflation. Second, from 1982–2000, the stock market (as represented by the S&P 500) experienced returns of 19.2% per year, for 18 years. We are not, however, arguing for a similar magnitude or duration today, but simply noting that the current length of this bull market does not by itself argue for its imminent demise. Rather, the important point to remember is that, as the old saw goes, bull markets do not tend to end just from old age. They end either because of a hostile interest-rate environment due to an overheating economy, a severe macro shock, or accelerating economic deterioration. Typically, it is a combination of these factors that sends the “bull” out to pasture. 

Outlook for 2018
So, as we assess the equity markets heading into the new year, one important note to raise is that we believe the bar for performance now is higher for stocks after a historical strong showing in 2017.  With higher nominal P/E multiples in some industries and sectors, it is necessary to identify companies with fundamental strength worthy of their valuations. Given that backdrop, we believe the following segments of the market remain attractive: 

Secular growth themes:

• High-growth themes like cloud computing, e-commerce, and breakthroughs among small- and mid-cap biotechnology stocks delivered strong investment results in 2017, and for good reason.  Many stocks in these groups delivered high revenue and earnings growth, either at the expense of weakening competitors or as part of transformational innovation.
• Biotechnology, however, had been under pressure since late 2015, when drug pricing became a target for regulation in a hostile political environment. However, many new drug trial successes and FDA approvals, including some from small to midsized immunotherapy companies, have refocused investor attention toward the massive upside potential in this space. We expect this industry to thrive regardless of the direction of GDP data or incremental moves in interest rates or inflation.
• The emergence of Amazon as a titan of e-commerce has been one of the most powerful forces of creative destruction in our generation, and it continues to weigh on traditional retail, even as the U.S. consumer continues to spend. Finding the big winners in e-commerce can provide the potential for exceptional long-term returns, as we expect a handful of these companies to continue their aggressive consolidation of market share.
• Outside the United States, themes such as the rapid maturation of the housing finance market in India and Malaysia continue to hold promise. This development has created a vibrant new industry in those countries, with the creation of mortgage finance products similar to those offered in the Western world, creating a massive wealth effect. Private lenders in this industry have delivered massive investment returns over the past five years, a trend that we believe is still in its early stages. Other themes that remain attractive for non-U.S. equities include the continued rise of luxury brands across Europe and Asia as well as the strong and accelerating growth of property markets within reemerging economies, such as Ireland.

Small-cap equities:

• The “small-cap effect” has long been recognized in academic studies as a powerful long-term tailwind, where more nimble companies are able to generate higher returns off lower asset bases than their more mature mega-cap counterparts, who find it more difficult to generate similar returns. Moreover, small-cap investors can potentially capture the fastest-growth phase in a company’s lifecycle, or locate companies that have substantial pricing power in niche markets.
• Nevertheless, small caps have underperformed mega-caps significantly in the United States for four calendar years now, with a roughly 2,300 basis-point performance differential, based on market averages.¹ This preference for the safety of larger, more mature companies could be coming to an end, as investor optimism about corporate earnings improves. We believe small- and mid-cap equities are much more attractively valued than slow-growth mega-caps, and have the potential to outperform going forward.
• We are very bullish on international small-cap equities, both because they remain a highly inefficient asset class—as they feature minimal analyst coverage, they are ripe for active management, with very attractive risk-reward trade-offs—and in light of the fact that some markets outside the United States are just now finally recovering from recessionary and deflationary pressures. We believe we could see multiple expansion and strengthening corporate earnings in the eurozone, as GDP growth there begins to finally inch higher, and as China’s economic activity appears to be much stronger than the dour expectations that caused such grave concern in late 2015 and early 2016. 

Value stocks:

• On the opposite end of the style spectrum, there are value stocks, an area that had thrived in 2016, but has lagged significantly in 2017. While an investor could just try to time a reversion to the mean of value in 2018, we would argue that it is critical to be selective and not view names in the various value-stock indexes as all alike.
• We continue to believe, for instance, that as we’ve transitioned from an investment landscape greatly influenced by the U.S. Federal Reserve’s quantitative easing moves to a more fundamentally driven market, many of the themes that worked during 2010–16 are not going to perform as well going forward. Specifically, we believe many bond-like equity sectors that drew investor assets during that period for their low earnings volatility and attractive income characteristics could continue to sell off as the economy strengthens, rates rise, and investors seek out risk assets and inflation proxies. 
• There certainly are names in the value segment that have been left behind due to a rotation to growth stocks in 2017. Of those stocks, selecting the ones with the strongest underlying fundamentals may yield attractive returns in the coming year.

¹Based on the relative performance of the Russell 1000^® Growth Index and Russell 1000^® Value Index.