My 2018 Outlook

As simplistic as it is, I believe that when attempting to predict the market action for the year ahead, it is necessary to first review the secular environment. Over the past century, our stock market has tended to take a staircase steps approach to progress. We see roughly 15 years of flat followed by roughly 15 years of forward. Consider 1968 through 1982. The Dow Jones Industrial Average reached 1,000 three times, only to fall back dramatically, before finally and permanently breaking through in 1982. Although the next seventeen years saw drops and frights, it did basically charge ahead until 1999. Next came a period with a drop of 25 percent, followed by recoveries to old highs, followed by a drop of 25 percent followed by a rise. It took until 2013 to break through the old record highs. That meant 14 years of volatile sideways drift. By this reckoning (breaking old peaks), we are only four years into a secular bull market, though I acknowledge that the popular press considers us nine years into it—using the market bottom as a starting spot.

I say we are midway through a secular bull market. However, it must be recalled that bull markets also contain severe drops. In October 1987, during the middle of the last secular bull market, we saw markets fall 22.5 percent in the U.S. and more overseas in a single month. Could we be at such a juncture? Could we be in a secular bull market with a shock to the system overdue? And if so, what’s an investor to do?

We know that economics matter. Looking ahead through 2018, higher corporate earnings — inevitable with the gift the U.S. government will be giving them in the form of lower taxes — ought to lead to the sort of volatility-free rise that 2017 saw.

Further, employment is full in this country; emerging economies continue to grow at rates that exceed those of developed economies; exciting new industries such as software-as-a-service, alternative energy storage and the internet of things arise with comforting regularity fueling dynamic growth. Stocks are pricey, but if we add five percent growth rates in (the result of a five percent cut in taxes) they are fair. Why worry?

Then there’s the other picture. There are two enormous longer-term and permanent threats to my cheerful scenario. One is a macro geopolitical one and the other is due to climate change. Further, there are three short-term unavoidable threats, also worth acknowledging.

I begin with the macro geopolitical fact that overhangs all if we look ahead a few decades: China. Earlier this year a report from the World Economic Forum pointed out that China graduates 4.7 million STEM scholars from colleges or technical institutions in a year while the U.S. graduates 568,000. With over twelve times as many potential entrepreneurs produced each year, China is positioned to take on global economic leadership during our lifetimes. The nation is building a university every week. Their GDP growth is over twice as high as ours, their literacy rates are comparable. A seismic shift from U.S. economic domination to Chinese economic domination is underway.

In an article about stock market behavior next year, we need not pursue this line much longer, but it cannot be ignored as the framework within which we look at current global risks. Russia may meddle in elections in democratic nations and create weakness, but it will be China that picks up the benefits.

Now consider climate change. This fall we witnessed extreme weather events in our nation. The taxpayer is picking up much of the bill. National Centers for Environmental Information enumerates the costs in billions: wildfires, droughts, hail, flooding, and tornadoes had cost the nation roughly $13.2 billion before Hurricanes Harvey, Maria and Irma arrived with their estimated $600 billion price tag. This is bad news; considering that our National Flood Insurance Program was already $25 billion in debt by August 2017. It is only a matter of time before the costs of these events create the next financial services collapse. There will be a year when New York or Miami is leveled, the entire seaboard is washed out, or an entire year’s worth of crops fails. Banks and insurance companies will refuse to engage in lending or selling insurance to entire regions. Once again, the shock will go global and markets will fail. Longer term, China and climate change are coming at us, but probably not during 2018.

Near term, the most immediate risk is North Korea. Deeply proud of their self-reliance, the nation is now under the leadership of Supreme Leader Kim Jong-un, who has accelerated his nation’s preparedness for the attack he expects. With 25 nuclear warheads, electromagnetic pulse bombs, sophisticated cyber warfare capacity and at least 5,000 tons of chemical weapons ready to launch, North Korea will not stop accelerating the production of weapons. Our behavior in Libya took that off the table. Recall that Libya’s President Muammar Gaddafi, agreed to give up all weapons of mass destruction, allowed inspections, in exchange for assurances of protection by NATO and Western allies. Within a decade, his supposed protectors intervened in the uprising in Libya and Muammar Gaddafi was hunted down to the culvert he was hiding in, then “shot like a dog.” Kim Jong-un will make no such mistake. However, he is not an aggressor. He views himself as proving his readiness to defend his nation. If we avoid leading him to believe he is under attack, he will continue down his albeit scary, but harmless-to-markets tact.

The second immediate threat is higher interest rates. The easy money position of global banks is ending. With its loss will come rising interest rates – creating investment competition for stocks.

Further, rising rates in a close to zero inflation environment will have a dampening effect on large sectors of the economy, like homebuilding, which counts on presumed higher valuations long into the future. Every firm on Wall Street estimates what a stock is worth versus the ‘risk-free’ alternative of Treasury issues. Rising rates make stocks seem more expensive.

The third immediate threat is a November election. Should Republicans fail to prove that they can govern (meaning should they fail to cut corporate taxes), that party will fracture further, giving Democrats a chance to regain leadership in the Senate, perhaps even state and local legislatures and the House. Any step in that direction represents greater regulation, corporations shouldering more costs, and increased government spending on services and infrastructure. Wall Street will be thrown into panic and the collapse will follow.

In the end, my belief is that we are still about half way through a secular bull market and that the 15 to 25 percent pullback that always happens during a secular bull market will be triggered by a rising Democratic party.

So where am I placing my funds? I’m almost all in. For me, a ten percent cash allocation is a conservative position; I’m there. Economics are strong; markets are going to get a boost; market drops of 15 percent come (on average) every two years; America still rules the world; the rich still take all and the rest lump it; nothing has changed. Sometimes what’s good for markets isn’t what’s good.

 

Article by Amy L. Domini, CFA  She is widely recognized as the leading voice for socially responsible investing. Her passion for the field has led her to create three businesses and to write several books. She has been awarded acknowledgements of these efforts, including: Time magazine named her to the Time 100 list of the world’s most influential people in 2005. That year she also received a citation from President Bill Clinton for her work with the United Nations Foundation. In 2008, Ms. Domini was named to Directorship magazine’s Directorship 100, the magazine’s listing of the most influential people on corporate governance. In 2014, she was awarded the Founders Award by New Yorkers Against Gun Violence for her advertising campaign (which ran in The Nation), urging investors to divest guns from their portfolios.

She is the founder of Domini Impact Investments (www.domini.com), a mutual fund company with $1.6 billion in assets under management. Ms. Domini is also founder of The Sustainability Group, which manages private client assets in Boston, MA. She has served on a number of boards, including the National Association of Community Development Loan Funds (now Opportunity Finance Network), an organization whose members work to create funds for grassroots economic development loans; and the Interfaith Center on Corporate Responsibility, the major coordinator of involved shareholders who file proxy resolutions. She is a member of the Boston Security Analysts Society.

Ms. Domini holds a B.A. in international and comparative studies from Boston University, and holds the Chartered Financial Analyst designation. In 2006, she was awarded an honorary Doctor of Business Administration degree from Northeastern University College of Law. Yale University’s Berkeley Divinity School presented Ms. Domini with an honorary doctorate in 2007.

Ms. Domini is the author of Socially Responsible Investing: Making a Difference and Making Money (Dearborn Trade, 2001) and The Challenges of Wealth (Dow Jones Irwin, 1988), and a coauthor of Investing for Good (Harper Collins, 1993), The Social Investment Almanac (Henry Holt, 1992), and Ethical Investing (Addison-Wesley, 1984). She contributes regularly to Optimist magazine and GreenMoney Journal. She lives in Cambridge, MA with her husband, Mike Thornton.