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Investment Outlook 2018

Earnings and interest rate forecasts suggest 2018 could be another good year for investors. But reasons for caution remain, including valuations and volatility. Brian Kilb and Kyle Tetting offer some of their insights in a Money Talk Video. A transcript of their discussion follows.

Brian Kilb: Kyle, 2017 is in the books. Many blessings for all of us, as it relates to the markets and portfolio returns. Just a fantastic year! I’ve been doing this a long time, I’m rarely surprised by anything. So, I don’t want to say I was surprised by last year, but I think if we went back to the beginning of last year and had made some predictions, very few of us would have had these kind of expectations.

Kyle Tetting: Yes, Brian. Extraordinary returns in stocks and bonds and stocks outside the U.S. You know, really, anywhere you look, the returns were compelling and in many ways, again, extraordinary, but I think there’s a lot to it – more than just great returns for investors.

Brian: For all the things there are to worry about, and there always are, people keep asking why did we do so well last year? And the story is pretty simple, I think. Corporate earnings rose give-or-take 11%, and the global economy has kind of kicked in, right?

So, you have growing earnings on a background of a solid economy throughout the world. It’s no wonder that stocks performed well.

Kyle: Yes, Brian. As we look at that growth, really, it could be much of the rest of the world that’s growing faster than the U.S., as we look ahead. And so that provides some opportunity for investors outside the U.S. – opportunity that we’ve just started now to recognize. A big part of returns outside the U.S. this year were just currency – that the dollar weakened a little bit, and U.S. investors benefited from that. But, as we look ahead, it’s that mismatch between economic growth here in the U.S. and much of the rest of the world that’s probably going to provide some opportunity for the long run for those investors.

Brian: Yes. So, it’s built on real fundamental data, and it’s built on strength. Now, the flip side of that is things to be a little bit concerned about. If domestic stocks were up 20% or more, maybe half of that came from earnings. The other half came from what we call expansion of multiples, which means people are paying more for those earnings.

We need to be a little bit careful about valuations as we’re paying more and more for each dollar of earnings. The price-to-earnings ratio is now in the 18s. Without bargains and with expensive stocks, your downside risk gets a little more important to pay attention to.

Kyle: Yes, and less of an issue, as long as interest rates remain low. And certainly, as long as inflation isn’t an issue, interest rates stay low. But, I think if we see inflation come back finally – after a decade plus of really being absent from the market in any meaningful way – and then you have interest rates respond to the expectation for inflation, now, all of a sudden, the pricing of stocks looks less favorable when you’re talking about paying a little bit more than fair value for stocks.

Brian: You know, you think about last year, and you boil it all down to earnings and low interest rates, it’s no wonder stocks performed well. But, maybe a bigger surprise was the bond market and how it held up. If you go back to the beginning of the year, most expectations were a rising rate environment, perhaps on a strong dollar, that bonds would weaken. And it wasn’t the case.

Kyle: Yes. Great year for bonds. And as we talk about kind of the academic side of investing and think about that efficient frontier, and looking at what the appropriate mix, or the appropriate balance is for investors, you know historically, we had always said that maybe 60 (percent stocks)/40 (percent bonds) or 50/50, right in between there was the right place to be for investors. And I think the challenge is, as stock returns have been so much higher recently, and as the volatility for stocks has been so much lower, it’s starting to shift the academic thinking a little bit more towards overweighting stocks. But, investors have to remember that that is now discounting a big chunk of volatility that really should be there that wasn’t last year.

Brian: People ask me all the time, what’s next year going to look like? I’m kind of interested in curbing everybody’s enthusiasm a little bit about the opportunities to make another 20% in stocks. And yet, it doesn’t mean that it has to be a bad year.

It could be a year where it’s kind of neutral, where things peak a little bit, where we crawl along instead of walk briskly.

Kyle: You know, Brian, I think my concern is that we’ve become complacent with volatility in the markets. Certainly, there’s every expectation that things can continue on the path they’re on. Maybe not quite as vigorously as they have, but certainly the economic outlook is favorable. The outlook for corporate earnings is favorable. And that tends to set up quite well for stock returns.

However, when you look at the lack of volatility in the last year, that’s not going to continue. And so, even if 2018 turns out to be a great year, you have the concern that there could be a correction at some point in time. You have the concern that there could be something unanticipated that causes stocks to fall a little bit. And if investors aren’t used to that, and if they respond to that volatility, they may be doing the wrong thing, simply because they just haven’t been used to a market correction or any kind of market reaction.

Brian: So, I think maybe for me, if the opportunity set isn’t as great as it’s been in the past, that perhaps my risk shouldn’t be as great as it’s been in the past. Not because I’m scared, or not because I need to be worried, but just because there aren’t as many upside opportunities perhaps.

Kyle: You know, the point about making sure you get balance right is the most appropriate piece. It’s not about trying to time when that correction’s going to come. We know you can’t do that. It’s not about trying to figure out exactly how much it’s going to fall and when the right time to get back in is. It’s really about making sure that you’re appropriately positioned for whatever might happen.

Brian: So, Kyle, I like to think of it this way: Match your risk to the opportunities that are presented.

Brian Kilb is chief operating officer and executive vice president at Landaas & Company.
Kyle Tetting is director of research at Landaas & Company.
Money Talk Video by Peter May and Jason Scuglik

Learn more
Investing amid synchronized global growth, a Money Talk Video with Marc Amateis
Valuing Investments: Price-Earnings Ratio, a Money Talk Video with Dave Sandstrom
Efficiently allocating assets, a Money Talk Video with Steve Giles
The Ups and Downs of Volatility, a Money Talk Video with Steve Giles
Corrections: A normal part of investing, a Money Talk Video with Marc Amateis

(initially posted Jan. 24, 2018)

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