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5 Experts Predict What Will Happen to Stocks in 2018

- Illustration by Ellla Cohan for Money
Illustration by Ellla Cohan for Money

A year ago there were real concerns that this bull market, the second-longest rally in history, was about to hit the proverbial wall. Rather than being gassed, though, domestic stocks raced ahead by more than 20% last year while many foreign equities did even better.

Did the bull truly get a second wind? And can it keep chugging along throughout the year and beyond? To help determine that, Money gathered a panel of market experts who run the gamut from being "cautiously optimistic" about stocks to being "bearish" in the long term. Joining the conversation, an edited version of which follows, were:

In their own words, here are the risks—and opportunities—that they see for the year ahead:

Can the bull market keep going?

We entered 2017 with a big question hanging out there: "Can the bull market—which was about to turn eight years old—keep going?" We learned the answer was a decided yes. So let's ask it again: Can the bull market, which is now about to turn nine, keep going in 2018?

Rob Arnott: Speaking as a bear, of course the bull market can continue. It continues until it doesn't.

Floyd Tyler, Founder, president, and chief investment officer for Preserver Partners - Andrea Morales
Floyd Tyler, Founder, president, and chief investment officer for Preserver Partners Andrea Morales

Liz Ann Sonders: I've been bullish for the whole bull market, and I remain so. But I think we're in or entering the latter part of the cycle, both in terms of the economy but also the market. So I think we have to start to be mindful of some of the risks.

Jim Paulsen: I agree a lot with what Liz Ann said. When I look forward, I don't really see the elements of a bear because I don't really see the elements of a recession. Not that you can't have a bear market without a recession, but it's not all that frequent.

I certainly see, increasingly, the elements of a rougher environment in 2018. I think you do want to be a little more conservative.

But I still don't necessarily see the end of the bull.

Sonders: It looks more like a "97 kind of period than an end-of-'99 kind of period. I'm not suggesting valuations aren't stretched, but when you look at the more egregiously overvalued stocks, circa 1999, I do think it's a bit different this time.

If this is more like "97 than 1999 or 2000, is it too early to become defensive?

Sonders: Well, I don't think one should ever make investment decisions based on a moment in time. The one benefit to the environment we're in is that it affords investors the opportunity to be disciplined, to use diversification to their benefit, and to actually rebalance on a more frequent basis.

Rebalancing is such an awesome tool that very few investors use appropriately.

Jim Paulsen, Chief investment strategist for the Leuthold Group - Glen Stubbe—Minneapolis Star Tribune/Zumapress.com
Jim Paulsen, Chief investment strategist for the Leuthold Group Glen Stubbe—Minneapolis Star Tribune/Zumapress.com

Arnott: I would endorse the comments about rebalancing.

That's one of the simplest forms of free money people can get their hands on, and most people don't. The temptation in a bull market is to buy more. The temptation in a bear market is to get out, which is the wrong thing to do.

The other source of free money is diversification. In a bull market, you regret having anything in diversifying assets, because those diversifying assets are holding you back. Then when the markets turn, you regret having too little in diversifying assets.

The sensible thing is to always have a decent slug of diversifying assets and stay the course with them. Don't flinch.

Floyd Tyler: It has to be true diversification, right—and not just small-caps and large-caps? That's not going to help you at all.

Arnott: Owning different flavors of domestic equities is not diversification.

Tyler: Right.

How frothy is this market?

Arnott: What I find fascinating is the dispersion in valuations. In the U.S., you have stocks at a Shiller P/E [a price/earnings ratio based on 10 years of averaged corporate profits] of 31, verging on 32 now. In Europe the Shiller P/E is half that. In the emerging markets, the Shiller P/E is what, 14?

Sonders: I'm not going to suggest that the market is inexpensive by any means. But just looking at the U.S., the Shiller P/E has been in overvalued territory for pretty much this entire bull market. And it was pretty much overvalued during the entire 1990s bull market.

Arnott: I don't want to leave the impression that I think Shiller P/E ratios are useful for market timing. They're not. But they do exhibit a remarkable correlation with subsequent 10-year returns.

Sonders: Absolutely.

Arnott: I look at today's Shiller P/E and don't draw a conclusion that the end of the bull is imminent. I do draw a conclusion that there are pretty high odds for a "lost decade" for equities going forward.

Where are the best opportunities?

Are there greater opportunities abroad because of valuations and other considerations?

Arnott: I would say absolutely yes. You look at the top 10 stocks in world market capitalization in 1990, and eight of the top 10 were in Japan. Was that a great time to buy Japan? I don't think so. In 2017, eight of the top 10 are in the U.S. Is that a great time to concentrate your investments in the U.S.? I don't think so.

Liz Ann Sonders, Chief investment strategist for the brokerage Charles Schwab - Ben Baker—Redux
Liz Ann Sonders, Chief investment strategist for the brokerage Charles Schwab Ben Baker—Redux

Tyler: I would agree except maybe with one exception—the United Kingdom. The U.K. looks like it's headed for a moderate recession. Other than that, I certainly would be shopping more outside the U.S. than in the U.S. We're tilted toward continental Europe and then Asia, and a little bit of Australia. We certainly think that if you have to allocate capital, and you want to do that responsibly, you should be shopping more outside the U.S.

Sarah Ketterer: I'm not sure I would say, "Put your portfolio abroad, and you're all going to be fine." I don't agree with that. I think all of these markets are overvalued … pulled up by technology euphoria. Look at the emerging markets. By far the best-performing stocks [last year] came from software services, technology, semiconductors. I think this market globally has become narrow and euphoric and completely blindsided to risks.

Arnott: I would say the best bargains are in the emerging markets. It's not the low-hanging fruit that it was 20 months ago. Compared to the rest of the world, it still offers some very good deals. I would go in with my eyes wide open. If there's a U.S. bear market, there will be a sympathy bear market in emerging markets. I'd keep dry powder, and I'd be ready to pounce if there are renewed bargains.

Paulsen: If we're now at a crossroads and turning toward some sense of reinflation, I think it does two things. It's going to benefit international economies much more than the United States in terms of earnings performance.

But I also think a 3% inflation rate has a special property in the United States. Below 3% inflation, every 1% increase in the inflation rate leads to a rising P/E multiple. But once you cross over 3% inflation, every 1% increase causes P/E ratios to decline by two points. There's a toggle switch in the United States in the financial markets around the 3% inflation rate.

Where are the bargains?

Paulsen: If we're all sort of cautious, where do we go to be cautious? Do you go to the traditional defensive plays—utilities and [consumer] staples stocks and telecoms and bonds?

Sonders: Jim, that's a great question, because a lot of those classic value areas like you mentioned—utilities, telecom stocks—there's no value there. That's kind of a conundrum right now.

Tyler: I think, broadly speaking, you're right. There's a lot of overvaluation in some of the typical [defensive] areas. But I think you'd have to look for discounting situations, event-driven situations. If you look at real estate investment trusts, for instance, they're broadly overvalued. But there's starting to be some interesting things in self-storage REITs and maybe some of the mall REITs. I just think we have to be more flexible, more opportunistic than we historically have been in looking at some of those areas.

Paulsen: I struggle with where to go too. The energy sector I think does offer a lot of attractive attributes. Both the relative price of energy stocks now relative to the market, and the relative price of oil relative to non-energy commodity prices, have both collapsed down back to very low levels. Fundamentally, energy has some defensive stock characteristics, like high dividend yields.

Should investors shift from the fast "growth" part of the market toward overlooked "value" stocks?

Paulsen: I do think some of that makes sense. Going back a little on tech and moving a little toward oil might be an example of that.

Sarah Ketterer, Chief executive officer and portfolio manager for Causeway Capital - Robyn Twomey—Redux
Sarah Ketterer, Chief executive officer and portfolio manager for Causeway Capital Robyn Twomey—Redux

Arnott: I'm a big fan of tactical asset allocation, which is over-rebalancing. When markets move to an extreme, take the opposite tack. But a cautionary note: Tactical asset allocation requires a cast-iron stomach. You're going to be so wrong, and so uncomfortable until you're right, that you're going to look and feel like an absolute idiot until you're right.

Sonders: The value-growth gap is huge. In fact you can go back, interestingly, to 1999 to see a gap [in performance between growth stocks and value stocks] that's similar to where we are today.

Arnott: The other thing that's interesting, if you look at [global] growth vs. [global] value stocks through the third quarter, on a 10-year basis growth has beat value by just over [three percentage points] per annum for 10 years. How much did it win by at the peak of the [late "90s] tech bubble? 2.9% per annum for 10 years.

I think that a tilt toward value makes sense. Doing a little bit of over-rebalancing makes sense. The one place where I think an aggressive value bet makes sense is in the emerging markets. That's where the spread between growth and value is at historic extremes.

Is inflation coming back?

Paulsen: We're very close to having a third quarter in a row of 3%-plus GDP growth, which is an extreme rarity for this recovery. We're pushing a 4% unemployment rate, 3% wage growth, and we've already got rising inflation expectations.

Are we now fully clear of all deflationary fears?

Paulsen: Saying "fully" scares the heck out of me. But yeah, I lean more toward the view that we probably are seeing some sense of reinflating in the world. It's not just a U.S. phenomenon. Core inflation is accelerating around the globe. It isn't a matter of having runaway inflation like the 1970s, but just a little inflation.

Arnott: Does that raise the risk of a policy error from the central bankers?

Paulsen: Well, it could.

Sonders: Yeah, I agree. And I think that there is sort of a two-part risk looking ahead in terms of monetary policy. The risk is either that inflation picks up and the Federal Reserve stays incredibly loose and continues to let asset bubbles inflate, or the Fed [raises rates] too quickly and risks a recession being sooner than we all have probably anticipated at this point.

What could trigger a selloff?

There's been very little volatility in the market lately. If we do see a pullback in stock prices, what do you think would trigger it?

Tyler: Well, it could be a geopolitical event. It could be maybe four or five rate hikes. It has to be something that leads to forced selling, so something that causes a lot of redemptions and it just starts to sort of spiral.

Arnott: I think looking for a trigger is always dangerous, because catalysts by definition are always a surprise. What was the proximate catalyst that caused the tech bubble to roll over and die? Here it's been 17½ years, and I still have yet to hear a credible explanation of a specific catalyst that caused that tech bubble to die, other than gravity. I think looking for catalysts is dangerous.

There will be a correction at some point, and there will be a bear market at some point, and whether the correction comes first or the bear market comes first is anybody's guess. I think it's high odds that next year we'll see a correction or a bear market.

So to sum up, how do you really feel?

Sonders: I'd call myself a late-stage bull. Maybe that's cautiously optimistic.

Rob Arnott, Chairman, chief executive, and portfolio manager for Research Affiliates - Robyn Twomey—Redux
Rob Arnott, Chairman, chief executive, and portfolio manager for Research Affiliates Robyn Twomey—Redux

Tyler: I'm warily invested right now.

Ketterer: We're focusing our efforts on very well capitalized companies globally because they may very likely hold their value even in rougher markets ahead. We're reducing portfolio risk—then preparing for an opportunity to add extremely high-quality companies, especially in emerging markets, with any type of market pullback.

Arnott: I'm a long-term bear, and I have a relatively indifferent view on a short-term basis. In the short term, the market could go up, down, or sideways. We'll opportunistically respond to those moves, but we see the long-term bargains elsewhere than in the U.S.

Paulsen: I'm more cautious than I've been for a while. I would be aggressive again if we get some kind of [stock market correction], and I'm still not convinced we're headed for a recession. Otherwise, I'm going to be fairly cautious—more cautious than I've been recently I guess.

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