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The Big Picture of the U.S. Stocks Heading into 2018

The year is in its waning days and barring a bombshell in the last couple of weeks, 2017 will go down as one of the most remarkable on records. Few investors expected the S&P 500 to post gains of close to 20% with near-record low volatility while enduring geopolitical tensions, massive natural disasters, political infighting in Washington, and a tighter monetary policy. This year has demonstrated why it can be detrimental under-exposed investors to wait for a pullback. As of this writing, we are in the longest period in S&P 500 history without a 3%+ correction, with no move of that size since November 4, 2016. Another mark of the steadiness of the market in 2017 has been the attention the small pullback we’ve seen lately has gotten—with some media pundits asking whether this marks the beginning of the end. We remain in the no camp, and believe that any pullback or correction would be a healthy development in the context of an ongoing secular bull market.

But while we think the bull market still has room to run and investors should remain at their long-term strategic equity allocations, it can be easy to get complacent after a year like this.

2018…Great Expectations

We believe the typical Wall Street exercise of publishing year-end stock market targets is of little value to Main Street investors, so we don’t dive into that pool. But we do believe that the secular bull market is intact as we conclude this year, but we expect a bumpier ride in 2018.

The U.S. economy has picked up steam; with back-to-back quarters of 3%+ growth and the Atlanta Fed’s GDPNow showing an estimated 3.2% growth in the current quarter. Additionally, the employment picture is healthy, with claims near record lows, unemployment at 4.1% and solid 228,000 jobs being added in November, according to the Department of Labor. Further, business and consumer confidence is booming, both the manufacturing and services Institute for Supply Management’s indexes show robust growth, and the Index of Leading Economic Indicators continues to rise. Housing is also picking up again, with housing starts rising nearly 14% last month (Census Bureau), and existing housing inventory is down over 10% year-over year (National Association of Realtors).

But there’s a rub to all the good news. Expectations are becoming elevated and could morph into a bar set too high for actual data to hurdle in 2018. As it is, the Citigroup U.S. Economic Surprise Index is at a level that has historically led to some mean-reversion. We’ve often said it’s both inflection points and relative growth that generally matter more than positive or negative growth in an absolute sense. In terms of corporate earnings growth, Thomson Reuters’ 2018 S&P 500 consensus earnings forecast is above 11%. Although a boost from tax reform is potentially in the cards, elevated valuations suggest that any disappointment relative to those expectations could bring heightened volatility and/or pullback risk.

Wild Card(s)

Tax reform is moving along, and odds are improved that it will cross the finish line; the final form is still in question, as is the ultimate impact on the economy. Judging by market movements on tax news, investors are optimistic about passage; while hopes for an infrastructure package seem to be falling as midterm election season heats up early next year. Finally, there is the Robert Mueller investigation wild card, which could also wreak havoc with investor sentiment.

There doesn’t appear to be any waning in the desire by the Federal Reserve to continue normalizing policy. However, with Jerome Powell taking over the Fed chair position in 2018, and several new members set to be appointed, uncertainty is elevated. Judging by the comments from Powell during his confirmation hearings, continuity and transparency are priorities; but if inflation should flare up, or growth start to lag, the Fed may be challenged early in the new regime.

So what?

Investors are cautioned not to extrapolate 2017’s performance into 2018, and we expect more frequent bouts of volatility. The global bull market is intact, supported by solid global growth and strong corporate earnings. But with the expectations bar now set quite high heading into next year, pullbacks are increasingly possible. Discipline is important looking ahead.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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