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January 2018
Three Surprises for 2018: Three-Peat?
By Michael Arone, CFA, 2017 in Review: Three for Three
Chief Investment Strategist,
Before I reveal my three surprises for this year, let’s
US SPDR Business
review how I did in 2017. After all, chief investment
strategists are only as good as their last forecast.
1. European Stocks Do Better Than Expected
Compared to the US, Europe provided better
economic growth, more attractive valuations, faster
corporate profit growth and looser monetary policy
Everything that happens once can never happen in 2017. This resulted in an attractive environment
again. But everything that happens twice will surely for European stocks to rally. And rally they did.
For the year, the MSCI Europe Index posted a 26.3
happen a third time. percent return in US dollars versus the still healthy
— Paulo Coelho 21.8 percent S&P 500 Index return. For US investors,
that’s a 4.5 percent cushion from owning European
stocks. This was a much better result than most
Each January for the last two years, I have forecasted investors expected from European stocks at the
three surprises for the market. These Uncommon Sense beginning of 2017.
articles were among the most widely read of the year. Even
2. US Pharmaceuticals and Biotech Rebound
though they know better, investors want to believe that folks
Maybe I’m my own worst critic, but I’ll call my second
like me — chief investment strategists — can peer into a
prediction about half right. The S&P Pharmaceuticals
crystal ball and predict the future. These beliefs are deeply
Select Industry Index had a positive absolute return
rooted in behavioral biases. Investors view strategists as
of 12.2 percent in 2017. Better than a sharp stick
experts and therefore tend to put too much stock in our
in the eye and definitely a rebound from its poor
market forecasts. The more confident the strategist, the
performance in 2016. However, pharmaceutical stocks
more likely investors are to follow the advice, regardless
trailed the healthcare sector’s return of 21.9 percent
of its accuracy.
and the broader market return. On the other hand, the
Despite these biases and my own skepticism about the whole S&P Biotech Select Industry Index rose a staggering
prediction business, I’ll oblige my readers once again this 43.9 percent, far exceeding the healthcare sector
year because as a chief investment strategist, like it or not, and broader market. Pricing concerns that plagued
forecasting is part of the gig. biotech stocks for much of the last year have largely
vanished as the Trump administration hasn’t followed
through with the price controls promised in the wild
2016 presidential campaign. The pricing debate has
given way to proposals for regulatory relief, increased
competition and value-based pricing. Plus, the new
Food and Drug Administration Commissioner Scott
Gottlieb has committed to expediting the drug
approval process. All this is music to the ears of
the biotech industry and their shareholders.1Three Surprises for 2018: Three-Peat?
Theoretically speaking, had Uncommon Sense readers Drumroll, Please: 2018’s Surprises
invested $50 equally in the US Pharmaceuticals
Without further ado, here are my three surprises for 2018:
and Biotechnology indices last year, their original
$100 investment would have increased to $128, 1. US Retail Stocks Rebound
garnering a roughly 28 percent return to outpace
2. Growth Stocks Beat Value Stocks…Again
both the healthcare sector and broader market.
3. Low Volatility Persists for Another Year
3. Initial Public Offering (IPO) Market Heats Up
According to the Financial Times, in 2017, global
exchanges attracted the largest number of listings US Retail Stocks Rebound: The Death of the
since the financial crisis. Data provider Dealogic
Retail Store Has Been Grossly Exaggerated
counted almost 1,700 companies floating shares
during the year, a rise of 44 percent compared to Growing up in the late 80s and early 90s, the mall was a very
2016 and the most IPOs since 2007. Proceeds from popular place. It’s where you worked, where you met up with
IPOs also rose 44 percent to $196 billion, the largest friends and, most importantly, where you brought your date.
amount since 2014.2 In fact, it was such a popular destination that many movies
and TV shows took place in a mall, culminating with the
I know what you’re thinking. I pulled the old bait
1995 cult classic Mallrats. No more! Malls are so yesterday.
and switch — using global IPO data to claim victory
Today, it’s all about online shopping and social media
for my third 2017 surprise when in reality US IPOs
experiences. Nobody predicted just how quickly retail
were still weak. But IPO researcher Renaissance
businesses would move online, how powerful Amazon
Capital claims that 2017 was the strongest year for
would become or how expensive it would be for traditional
US IPOs since 2014, with 160 offerings through mid-
retailers to transform their business models.
December. Admittedly, 160 IPOs is far less than the
275 launched in the more bullish 2014 environment. According to the Financial Times, at least 50 US retailers
However, US companies raised $49 billion in 2017, filed for bankruptcy in 2017, the most in six years. This
more than double the $24 billion from listings in includes former household names like Toys ‘R’ Us, the
2016, the worst year for IPOs in more than a decade.3 children’s retailer Gymboree, shoe store Payless and
So, although the hurdle was low, I’m claiming victory jean maker True Religion. With nearly $6 billion in high-
because 2017’s US IPO market was definitely a lot yield debt set to mature in 2018, many observers expect
hotter than 2016’s dud of an IPO market. this retail distress to accelerate in 2018. Moody’s list of
distressed companies includes 26 US retailers, the highest
That’s three for three. I’m as dumbfounded as you. And for number since the recession.4 The defaults and bankruptcies
those keeping score at home, when you add 2017’s correct are already having far-reaching consequences, with
calls to my record from 2016, I’m pretty much six for six concerns over how store closures will affect the nearly
in forecasting surprises for the last two years. Probably 16 million Americans that work in the retail sector.
just dumb luck. Needless to say, US retail stocks are unloved.
However, reflecting on the formula that has led to my That said, US retail stocks possess all of the attributes
so-called forecasting success reveals some important steps. that make for a likely positive surprise in 2018. They are
First, I limit the number of surprises to three. Unlike some universally despised by investors. Using a forward looking
of my strategist peers, I don’t try to predict every plausible 12-month price-to-earnings ratio, US retail stocks trade
surprise or asset class return. That’s a recipe for failure. at a 25 percent discount compared to the S&P 500 Index.
Second, the forecast horizon is reasonably short-term, just In an investment landscape void of compelling valuations,
one year. Third, my process has remained the same each US retail stocks may offer investors seeking reasonably
year, so it’s both consistent and disciplined. Finally, I’m valued assets an opportunity. Some modestly positive
simply looking for unloved assets with compelling valuations news could be a catalyst to lift retail stocks out of the
where bad news is already priced in and investor opinion on doldrums. According to the Commerce Department,
the asset is decidedly one-way. Assets that exhibit these US consumers shopped at a strong pace in December,
characteristics are ripe for surprises. This simple four-step closing out a healthy holiday season for retailers. Retail
process may be helpful to investors as they think about sales rose 0.4 percent in December, after a 0.9 percent surge
modifying their own portfolio allocations in the new year. in November. In 2017, retail sales rose 4.2 percent, the most
in three years. Strong holiday shopping should lift fourth
State Street Global Advisors 2Three Surprises for 2018: Three-Peat?
Figure 1: Despite Strong Macro-Support, Retail Short in a slow growth environment. Interestingly, growth and
Interest Relative to the Broader Market Is Higher value stocks in the US returned about the same from
Than During the Recession the start of the current bull market in early 2009 until
January 2017. This was largely attributable to the surge
Short Interest v. Float Ratio Gap
in value stocks after the US presidential election in
16 7
November 2016. According to The Wall Street Journal,
14 6 since then the nearly 20 percentage-point outperformance
12 5 of growth stocks is the most in such a short time period since
10 4 the last year of the dot-com bubble.7
8 3 Today, higher expected economic growth, rising interest
6 2 rates, tighter monetary policy and increasing inflation
expectations have convinced investors that 2018 will be
4 1
value’s time to shine. In addition, after more than nine
2 Apr Sep Feb Jul Dec 0 years of the current economic expansion, investors expect
2008 2010 2013 2015 2017
that many classic value sectors (i.e. energy, materials and
Gap — Short Interest v. Float Ratio for Retailing industrials) will outperform in the later stages of the
— Short Interest v. Float Ratio for Total US Market economic cycle. Investors are confident that the huge gap
between growth and value performance must close soon.
Source: Bloomberg Finance LP, as of December 29, 2017. In fact, in December, investor flows into value-oriented
Exchange Traded Funds (ETFs) trounced flows into
growth ETFs by a whopping $5 billion. Despite the sizeable
quarter US economic growth. In November, the Conference
difference in performance between growth and value,
Board’s Consumer Confidence Index reached its highest
unusually, investors allocated more money to value ETFs
level since 2000.5 According to Deutsche Bank Research,
in 2017 than to growth ETFs, to the tune of $7 billion
household net worth is at an all-time high and low debt
more to value versus growth. Investor conviction that
servicing costs are helping to support family finances.6
value will beat growth this year is getting dangerously
Rising stock and house prices have also bolstered consumer close to being one-sided.
confidence. With the unemployment rate at just 4.1 percent,
This all convinces me that growth stocks are likely to
the lowest it has been in 17 years, many expect wages will
continue their dominance over value stocks this year.
begin to accelerate more quickly. And the Tax Cuts & Jobs
Although US economic growth, interest rates and inflation
Act means many taxpayers will have lower tax rates this
expectations are rising modestly, I believe that the current
year. This will result in higher take home pay and more
environment is still characterized by below trend growth,
disposable income for many families. Expectations for
historically low rates and benign inflation. US GDP growth
rising inflation may provide retailers the key ingredient
is likely to increase by roughly 0.5 percent in 2018
they have lacked in recent years — pricing power. Combining
bolstered by rebuilding from last year’s hurricanes
this new pricing power with lower corporate taxes has led
damage, momentum in the mining and manufacturing
to an increase in earnings growth expectations for retail
sectors and the passing of the Tax Cuts & Jobs Act. Despite
stocks. Lastly, short interest in US retail stocks is high. If
the improvement, US GDP growth is expected to remain
the stocks begin to rise, short investors may get squeezed
stubbornly below the 3 percent threshold this year. The yield
and a major positive reversal in stock prices could occur.
on the 10-year US Treasury has increased meaningfully from
Taking all this into consideration, it may be time to go the recent lows set last September. Currently, it hovers
shopping for bargains in US retail stocks. around 2.6 percent, still 45 percent below its 20-year average.
Additionally, the Bureau of Economic Analysis released the
core (excluding food and energy) personal consumption
Growth Stocks Beat Value Stocks…Again: expenditures (PCE) index in late December. At 1.5 percent
Same Old, Same Old year-over-year, the Fed’s preferred measure of inflation
It’s been a tough few years for value stocks. Growth stocks, continues to fall considerably short of its 2 percent target.
largely led by technology shares, far outpaced value stocks And, with wages as measured by average hourly earnings
in 2017. In fact, the performance difference between cheap stuck at 2.5 percent year-over-year, wage growth doesn’t
value and pricey growth stocks is the largest it’s been since appear to be the near-term catalyst to spark a rise in
the dot-com bubble, as investors have been chasing the inflationary measures.
performance of companies with rising corporate earnings
State Street Global Advisors 3Three Surprises for 2018: Three-Peat?
Figure 2: Value’s Higher Beta to a Steepening Yield Curve, Figure 3: Daily Market Volatility Has Only Been Lower in
Rising Long Term Rates, and Higher Inflation Expectations One Other Period, Over 50 Years Ago
Beta %
4 3.0
2.10 2.35
2.5
2 1.33
2.0
0 1.5
-1.29 1.0
-2 -2.10 -2.17
0.5
-4 Yield Curve (10-Year vs. 2 Year) 10-Year Yield Changes in 10-Yr Inflation 0.0 Jan Jan Jan Jan Jan
Expectation 1930 1952 1974 1996 2018
Beta of S&P 500 Value Excess Returns Over the S&P 500 Index — S&P500 Daily % Change (Absolute Values, Rolling 12-Month Average)
Beta of S&P 500 Growth Excess Returns Over the S&P 500 Index — Lowest Reading (0.26%)
Source: Bloomberg Finance L.P.,January 17, 2018. Source: Bloomberg Finance L.P., FT Research as of January 17, 2018.
Unprecedented monetary policy actions over the last decade levels in the history of the CBOE Volatility Index (VIX) since
have distorted the economic cycle. As a result, it is difficult 1990, 47 of them occurred in 2017.9 Elevated US stock
to determine the current stage of the economic cycle. Some valuations combined with the increasing possibilities for
now argue that the removal of emergency monetary policy political instability also support the forecast for greater
conditions will finally start the clock on the real business volatility this year.
cycle. If they are right, the economy may still be surprisingly
What makes me so sure volatility will remain low?
in the early stages of the economic cycle. Historically,
Continued improvement in passable GDP growth without
classic growth sectors (i.e., healthcare, financials, consumer
a commensurate pickup in inflation, notably wage inflation,
discretionary and technology) perform well in the early
likely will keep the environment tranquil. In addition,
stages of the cycle. In an environment defined by still
flat-lining measures of inflation are likely to keep the Fed
modest economic growth, low rates and benign inflation,
at bay for most of the year. While normally, a tightening
investing in growth stocks whose top-line revenue and
of monetary policy conditions results in unexpected bouts
earnings are growing much faster than the overall
of volatility and financial crises, I expect the Fed under its
economy is a good strategy for some investors.
new leadership to continue on its glacial, well-telegraphed
Notwithstanding the popular belief that value will finally pace of monetary policy tightening. As a result, monetary
prevail in 2018, I expect growth stocks to continue their policy will contribute to still easy financial market
recent winning streak this year. conditions. This will keep investors calm for a while longer.
For more than 30 years investors have come to expect the
central bank put option to save their bacon when volatility
Low Volatility Persists for Another Year: and unexpected events collide. From my perspective, it is
Talk About Bucking Consensus the primary reason why all measures of financial asset
The most common prediction for 2018 is that volatility volatility sit at multi-decade lows.
will increase this year. Why? The simple answer is that Still not convinced that volatility won’t spike in 2018?
it was historically low last year and has been unusually Curiously, another reason why broad-market volatility
low for the last several years, so investors believe it’s due to remains so low is because low stock-specific correlations
rise. According to the WSJ Market Data Group, the absolute continue to fall. Correlations, or the degree to which two
daily percentage change of the Dow Jones Industrial Average different stocks move in tandem with each other, have
was 0.31 percent in 2017. It was 0.30 percent for the S&P 500 dropped sharply of late. For stocks in the S&P 500,
Index. This represents the smallest absolute daily percentage correlations are at 0.1, according to data from S&P Dow
change since 1964 for both market indices.8 For the Nasdaq Jones Indices, well below its median read, which is close
Composite Index, the absolute daily percentage change was to 0.35.10 A reading of zero would represent no correlation
0.44 percent, the smallest since 1989. Of the 56 lowest closing whatsoever, while a read of 1.0 would represent perfect
State Street Global Advisors 4Three Surprises for 2018: Three-Peat?
Figure 4: Stocks Moving In Different Directions Crystal Ball or Dumb Luck?
Make Broad Spike in Volatility Less Likely
In spite of my accuracy over the last couple of years, I hope
Correlation you know by now that I take my forecasting success with a
1.0 big grain of salt. And you should too. It’s a fool’s errand to
peer into a crystal ball and make prognostications. The more
0.8
important lessons to glean from this month’s Uncommon
Sense are to keep it simple and don’t try to forecast too much
0.6
in one sitting. Know your investment time horizon for
0.4 tactical investment ideas and follow a repeatable, disciplined
approach to investing. While you can never control
0.2 investment outcomes, you can control the process — that’s
one of my favorite investment lessons. And remember that
0.0 Jan Sep Jun Feb Jan wonderful surprises occur in assets that are unloved and
2007 2009 2012 2015 2017
undervalued, where there is plenty of bad news priced in
— Intra-Portfolio Correlation S&P 500 Index — Historical Avg and the consensus opinion is that things can only get worse.
Source: FactSet, January 19, 2018. 2018 will have its fair share of surprises. What they are,
only time will tell. Again, my surprises for this year are that I
expect US retail stocks to rebound, growth stocks to beat
correlation. Volatility tends to be elevated in periods of
value stocks…again and low volatility to persist for another
high correlations because stocks move in the same direction
year. Happy hunting! I wish you good fortune in finding your
at the same time, and such broad-based moves are reflected
own investment surprises in 2018!
in the major indexes. With correlations between stocks as
low as they have been in a while, the VIX is going to have 1
Sy Mukherjee, “Why the Biotech Market Has Come Roaring Back.” Fortune.
trouble rising. August 4, 2017.
2
Nicole Bullock, Robert Smith and Emma Dunkley,“Global number of IPOs highest
Sure, compared to the incredibly docile 2017, we’ll likely since financial crisis.” Financial Times. December 27, 2017.
see some bouts of volatility in 2018. But, much like all of the 3
Renaissance Capital, “2017 IPO Market: Good, But Not Great.” January 2, 2018.
volatility spikes we have experienced in the post-Global 4
Eric Platt and Anna Nicolaou, “US retail’s turbulent relationship with private equity,”
Financial Crisis era, from Brexit to Trump’s election night, Financial Times. December 29, 2017.
any volatility is likely to be short-lived. As a result, I expect 5
The Conference Board, Consumer Confidence Survey, December 27, 2017.
the VIX Index, Wall Street’s so called “fear gauge,” will 6
Robin Wigglesworth, Sam Fleming, “Traditional US Retailers Gain on Holiday Sales
likely on balance remain well below its 10-year average of Hopes,” Financial Times. December 26, 2017.
slightly more than 20. 7
James Mackintosh, “Investors Finding Little Value in Value Stocks, So Watch for
the Rebound,” The Wall Street Journal. November 28, 2017.
To sum up, with the market melt-up entering its euphoric 8
“The hidden reason why stock market volatility has been so low,” Marketwatch.
phase, decent economic growth, little inflation, an January 8, 2018.
accommodative Fed and low stock-specific correlations, 9
“The hidden reason why stock market volatility has been so low,” Marketwatch.
I expect another year of low volatility in 2018. January 8, 2018.
10
“The hidden reason why stock market volatility has been so low,” Marketwatch.
January 8, 2018.
State Street Global Advisors 5Three Surprises for 2018: Three-Peat?
Glossary
Consumer Confidence Index An indicator designed to measure consumer
confidence, defined as the degree of optimism on the state of the economy that
consumers are expressing through their activities of savings and spending.
MSCI Europe Index The Morgan Stanley Capital International Europe Index,
a free float-adjusted market capitalization index designed to measure developed
market equity performance in Europe.
S&P 500 Index A popular benchmark for U.S. large-cap equities that includes
500 companies from leading industries and captures approximately 80.
S&P Biotech Select Industry Index A modified equal-weighted index that
represents the biotechnology sub-industry portion of the S&P Total Markets Index.
S&P Pharmaceuticals Select Industry Index A modified equal-weighted
index that represents the pharmaceuticals sub-industry portion of the S&P Total
Markets Index.
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