The market entered 2018 with the bulls in charge. 

While such a strong start may be surprising, it is consistent with a strong global growth picture. 

• US GDP in the 3rd quarter of 2017, grew 3.2%, a pretty respectable rate.
• Anemic Europe managed to grow by 2.5%.  Even Italy, the weakest major European economy increased by 1.8%.
• Equally maligned Japan put in a much improved 1.8% GDP growth.
• China was up over 6%.

With higher commodity prices, other emerging markets also improved.

Corporate friendly tax structure for US

Late in the 4th quarter, the US voted in a new tax structure that greatly benefits US corporations.  Lower corporate taxes increase corporate profits.  Add a favorable tax policy to a landscape of better global economic growth and you have a strong argument for higher stock prices as corporate earnings are the long-term driver of stock prices. 

Profit expectations priced into the market

There is an argument that the market has priced in a good deal of profit expectations. The S&P500 trades at a multiple of about 18 times 2018 earnings.  That’s not cheap.  It’s well above the 15 times experienced in 2007 but well below the 24 levels before the Tech Wreck in 2000. 

Pessimism and liquidity affect stock prices

During the current bull market which began in 2009, pessimism was consistently high.

Pessimism

Sentiment is a contra-indicator and so long as there is pessimism concerning the market, stock prices are likely to go higher.  Pessimism has been waning and more analysts are upgrading their opinions of the market.  This is a concern. 

However, despite signs of speculation in Bitcoin, art, and some areas of technology, we are not yet in a state of euphoria.

Liquidity

The next factor that is important to stock prices is liquidity.

Global Central Banks have been pumping money into the system since 2009. Liquidity drives stock prices and all prices for that matter. Central Banks are beginning slowly to pull away from the punchbowl.

• The US Fed is raising rates and beginning to reduce its balance sheet.
• The European Central Bank has yet to do so but has hinted that “normalization” is not far off.

Like sentiment, liquidity is moving from being market supportive to market negative.

In summary, the likely path for stock prices remains upward.  Small US companies may outperform as they will benefit more from tax reductions and US growth than large companies. 

What could surprise the markets in 2018?

I think commodity prices and a pickup in inflation.

From 2009 until the present, as a result of lackluster demand, capital expenditures, and capacity in most commodities have declined. It takes time to restore lost capacity and supply can’t keep up with an increase in demand.

We are seeing this in the oil market and in metals such as copper and iron ore. 

Unemployment is already low and with fiscal stimulus from tax cuts and possible infrastructure programs, wage rates may push up as well. If inflation expectations finally move up, long-term interest rates will rise. 

Could this trip up the bull market? Probably not for a while but I wouldn’t rule it out.  

— Ian Green, Pendragon Capital Management

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Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.