2018: A Challenging Year Might Be Ahead

“Whatever has the nature of arising, has the nature of ceasing.” – The Buddha

First thing first: I hope you had a wonderful Thanksgiving with your family and loved ones, and wish you a great Holiday Season, Christmas, News Year….under whatever name, shape or form you enjoy celebrating. My usual attitude I have adopted from a longtime friend is: “Is there something to celebrate? What are we waiting for?”

If you have read my previous newsletter, you might recall the above quotation and might be wondering if I have forgotten something. No, I haven’t. When I sat down to produce this quarter’s letter, I realized that I couldn’t have found a better quote, so I kept it.

As we’re approaching a new year, following a period of strong performance, many of you are probably nervous or wondering if a deep correction is due. Common questions are: Is this time to sell? Is there more room for growth? Should I invest now or wait for a downturn?

For those looking for quick answers: not yet; probably yes; and what about dollar cost averaging?

It all depends on your goals, time horizon and risk appetite. To demystify my answer, let’s dive in.

Cry Wolf

The current market regime we are in might be best described as the “most hated bull market in history.” For years, many participants have been calling for a correction and yet here we are, with solid returns.

I can not tell you how many client meetings I have had since 2011, making a bullish case, settling a client’s nerves, who had just read a report suggesting that huge losses were ahead.

There is actual research showing that some republican leaning investors had missed out on the “Obama rally”. It looks like now it is the democratic and liberal leaning investors’ turn to sit on the sidelines and watch the market that they so “hate”, to run up.

Looking at valuations and extreme optimism, is this “the” time to go out and save the shepherd from the wolves? If we do so, will we look like fools, again? There is a third way.

Don’t Throw the Baby Out with the Bathwater

There is plenty of research that shows that the majority of portfolio returns come from asset allocation decisions. In other words, whether or not you will be invested in stocks, bonds, alternatives or stay in cash, is the most important decision. The effect of security selection, is miniscule compared to this very fundamental decision.

That being said, like most things, it is not black and white. You should make buy all, or sell all decisions. Better said, fine tune your asset allocation, to fit the current investment regime.

We are not bound to decide whether to fully get out of the market, or blindly stay in it. Instead, we need to keep our eyes on current market drivers, pay close attention to our time horizon and investment goals, and make adjustments accordingly.

Current Market Drivers

I am fortunate to serve many clients who are smarter and better educated than myself. One of them once told me “I don’t get what you’re doing, it seems so complex.” Coming from a man with a PhD in computer science, I was humbled, but to tell you the truth, it isn’t all that complex, it all boils down to:

Markets go up because there are more buyers than sellers.

Economies grow because more money is spent this year than last. So, the two most important components are: 1 – How much money is out there? 2 – What is the investor/consumer sentiment? In short, it’s all about the FED and psychology.

How about valuations? Research shows that valuations are better indicators for long term (5-10 year) returns, but have a terrible record for shorter term (1-3 year).

The FED, crowd psychology, the economy and politics are undoubtedly interrelated but the end-result on investments has to be separately and carefully analyzed.

We still have a friendly FED, an overly optimistic crowd, a strengthening economy and a market friendly tax bill on its way.

Not too shabby, however the key word here is “overly”. In spite of Keynes’ famous quote “Markets can stay irrational longer than you can stay solvent.” overly optimistic sentiment usually gets punished shortly after.

So…2018?

If you think I am giving mixed messages, that’s because I am. On one hand, I know that when the FED is friendly, the crowd is optimistic, the economy is strong and politicians are market friendly, fighting against this picture is foolish.

On the other hand, looking at historically high valuations, very little cash sitting on the sidelines, and extreme investor optimism, this might be the time to give the shepherd who cried wolf, the benefit of the doubt.

Action Items

How to reconcile these two sentiments?

• Clarify the purpose of your investment. If you have a long-term goal, short term fluctuations shouldn’t scare you away from investing, but if you may need these funds within a year, this might not be the best time to get in.
• Brace yourself for volatility. 2018 probably has one or two 5-10% pull back(s) built in to it. So, consider how to lower stock exposure, raise cash, or prepare yourself to ride the roller coaster, and have a 10% drop in US stocks as one of your what if scenarios.
• Make sure you’re diversified. Usually, what went up the most, comes down the fastest. In the current case, it is the tech stocks. Make sure your tech stock exposure is in line with your risk appetite.
• Have some international exposure. While the US FED is raising rates, European and Japanese central banks are still in their easing mode, most likely till the end of 2018. These countries, along with Emerging Markets may offer better value.
• If you’re overly concentrated in any particular security, look for strategies such as put options.
• Don’t be afraid of raising cash.
• Watch for earnings because the market is priced for perfection and a negative surprise could be the black swan in the lake.

In Short

2018 will likely end up being a positive year, but returns may be muted and may come with volatility. So adjust your strategy accordingly.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.

The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.