Morgan Stanley
  • Wealth Management
  • Mar 29, 2018

Listening Closely to Markets

2018 is playing out as we expected, but we’re monitoring six market trends to stay on track.

Relationship experts say that misunderstandings are often the result of miscommunication or an inability to communicate effectively. These deficiencies are usually the result of one party failing to listen. I am sure we all have many examples in our lives where we failed to listen to the other side before speaking and it cost us dearly, or at least more than it should have. If we had only listened more closely, it would have ended better.

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Over the years, I’ve found markets to be the same way. If I’d only listened more closely I would have seen it coming! As a result of learning this the hard way, I have developed an investment philosophy of “trust but verify.” Specifically, trust your fundamental analysis and investment thesis, but verify it by listening closely to what the market is saying.

Our outlook for 2018 is less bullish than the past year’s outlook (see “Don’t Expect an Encore,” from January 2018). This view is based on the fact that we experienced one of the best two-year periods in stock market history and therefore a lot of good news has already been discounted. Specifically, economic and earnings data were very strong and are expected to remain so. The problem with good news is that it gets people excited about the future when in fact the news may have already been priced in.

Our call for U.S. equities in 2018 is that earnings and economic growth will be strong, but the rate of change may be topping. Investors may pay lower valuations for those earnings because the tax cuts passed late last year are a one-time boost to growth. They arguably result in lower-quality growth as compared to the growth of the past few years which came from rising revenues and profitability. 

We have started to tilt our sector preferences more defensively with our recent upgrade of utilities, our reiteration of our overweight in energy and our underweight in consumer discretionary. We think foreign equity markets will offer better returns than the U.S. given the lower valuations which reflect lower expectations—a good thing when investing. 

This year we continue to expect higher volatility and less predictable returns. Even though 2018 is playing out much like we expected, we would still like to verify it. So, we have created a checklist. Here are six trends we’re watching to make sure our analysis is still on track:

  • P/Es of U.S. stocks should contract. This is already happening and the S&P 500’s P/E now sits close to our target of 17. This means U.S. stocks are close to fair value today and should move in line with earnings, which are likely to continue to rise this year. Outside the U.S., P/Es still have room to expand, which is why we favor those regions. We especially like Europe and we recommend not hedging the currency risk given our view that the U.S. dollar will remain weak.
  • Volatility should remain high. Interest rate and currency volatility will lead the move higher in equity volatility. This, too, has happened and we expect these volatility measures to remain at higher levels than last year. As part of this changing dynamic, we expected at least one if not several 10% corrections this year. We just had our first. Get used to it because that is more normal than what we experienced in 2017.
  • The breadth of the market should narrow. That just means fewer stocks are participating in the rally. That is a sign of weakness much as increasing breadth is a sign of strength. Indeed, fewer stocks are doing well this year even though the equity market is up.
  • Financial conditions should tighten this year. Credit spreads are already widening and we suspect this will continue throughout the year as the Federal Reserve, the European Central Bank and other central banks remove monetary policy accommodation. Another verification: High yield credit has underperformed this year.
  • Earnings may disappoint. While earnings revisions and year-over-year growth have not yet rolled over, they are now at such high levels we think it is inevitable they will fall later this year. We will be watching this rate of change closely along with incremental operating margins, which are also apt to peak this year.
  • Defensive sectors may outperform. Earnings estimate dispersion should widen as economic leading indicators and data surprises begin to soften and the global economic expansion becomes less synchronous. Ultimately, this means defensive stocks start to lead the market. To this end, we recently upgraded utilities in the U.S.

We will continue to monitor this checklist and other trends to verify our thesis for 2018 and revise if necessary. Until then, we stand by our 2018 outlook for more modest returns—even negative for some asset classes—and higher volatility.