The finest trick of the devil is to persuade you that he does not exist
I've my own version of this: 'the finest trick of the devil is to persuade you that social sciences exist.'
Although my background is economics, during my years in the market, I've loosen up the idea that Economics is a proper science. It is wrong to use the argument that if you can calculate the trajectory of a rocket with the correct inputs, then you should also be able to calculate the trajectory of the economy and the markets. The root problem here is that, while in physics we are just observers and our expectations will not affect the trajectory of the rocket (not in quantum physics though), in economics our expectations will affect the course of events, thus making forecasting unreliable.
That is why, though I use valuation technics, I never buy or sell just based on valuations. You need to see the broader picture. That includes macroeconomic, sociologic and even demographic considerations.
Navigating the sea on tailwinds, while avoiding headwinds, has proved invaluable. Trading without a proper framing is chaotic, and having an idea, simplistic or even downright wrong, about where we are headed is priceless. Even if the market proves your assumptions wrong, you can avoid losses and pain if you just see it as a red flag and move to the sidelines. For all that, you just need proper framing.
Digesting the market action in 2017
That bring us to the first main point of this article. In the beginning of 2017 I defined 4 main working hypotheses:
WH1: After a credit market test, China will have a couple of stable quarters. China's Communist Party (CCP) badly needed this breathing room, but Trump's plans might bring instability to the table.
Graph 1 - SSE Composite (Nov 2015 to January 2018) Source: Google Finance
This proved right. Trump did bring some instability to the table, but China recovered well from the scare in the beginning of 2016. I did not have any trades directly related with China, but I was worried about a possible contagion to the US and Europe.
WH2: Trump's political measures have the potential to disrupt the current balance, sparking inflation and improving the US economy, but there will be roadblocks that the current consensus seems to be ignoring.
Graph 2 - S&P 500 (October 2016 to January 2018) Source: Google Finance
This one was right. The fastest gains came during the first couple of months after the elections. Then, from April until August, after some political defeats, the market seemed to lose part of its euphoria. Only after it became increasingly evident that some form of fiscal reform could be approved, did the market resumed its fast pace.
WH3: The EUR and European Equities will keep its subpar performance even if perspectives improve slightly.
Wrong, downright wrong. My pessimism towards Europe was biased by the fact that I live here. I find the EU and its institutions completely out of touch with reality. However, some variables came into play during 2017. The elections in France were the tipping point, all hopes were on Emmanuel Macron and a defeat could mean a Frexit and a collapse of the EUR.
Even after assuming a wrong scenario, I changed my mind after seeing the market action and the developments in the political scene (French election polls) contradicting my initial assumption. After the polls started to consistently reveal Macron as a strong contender, I altered my positioning of being on the sidelines, and built an overweighted position in European periphery banks. It worked just fine.
WH4: The pound will recover some of the ground it lost right after the referendum outcome.
In retrospect, I got this one right. However, during the year, I've never felt convinced enough to enter the UK stocks I had in mind. That was unfortunate, but I still believe it is better to stay in sidelines than to enter in a trade when your conviction is low.
Graph 3 - GBP/EUR vs GBP/USD vs GBP/CHF vs GBP/CAD during 2017 (Source: Google Finance)
Graph 4 - FTSE 100 vs S&P 500 and Eurostoxx 50 in 2017 (Source: Google Finance)
All-in-all, I got some hypothesis right and some wrong. In the end of the day, you can always count on a 50/50 chance of being right. For me, in 2017, what really made the difference was the ability to act when evidence showed that the initial assumptions were wrong.
Looking ahead, some of the themes that influenced 2017 will keep some momentum in 2018.
Considerations for 2018
WH1 - Fiscal reform will set in motion a couple of dynamics that will heat the economy.
JP Morgan has just announced a 10% raise in salaries, while hiring some extra thousands. Wall-mart seems to be on the same token. Dumb money, repatriated earnings and fiscal reform will heat the markets and the economy even further. Money on the sidelines will feel like they are missing the party, and equities should profit from it. Bonds, on the other hand, are poised to suffer.
WH2 - Europe and Emerging economies should benefit from the spillovers from the US.
This points towards a sellers' market. Everyone will want a piece of the action and when the traditional markets seem too expensive, buyers will turn to alternatives in Europe and Emerging markets.
WH3 - Commodities supply is quasi-fixed in the short term, if WH1 and WH2 materialize, then commodities should go up.
If consumers pick up spending and corporations pick-up production, then commodities will see an increase in demand. If WH1 and WH2 materialize, we should see support for the price of commodities, because in the short-term it is almost impossible to ramp-up commodity production.
WH4 - With growing inflation expectations, interest rates are also poised to rise. This will cause market participants to reprice assets. This will lead to turbulence in the market and not all equities will be winners, some will be repriced lower due to higher sensitivity to interest rates. This already happened once in 2018.
From a pure mathematical mindset, it makes sense to have a repricing due to higher discount rates. However, from a business standpoint, there will be businesses more sensitive to higher interest rate than others. Therefore, as the year goes by, we'll have various moments of reappraisal in different markets.
More than one month is already gone, and we have already witnessed euphory and turbulence. The initial rise was not going to be a constant throughout the year and we'll most likely see more reactions along the way. However, the tone should be a positive one for 2018, but remember that this late cycle might be tricky. Unlike what we have seen during 2017, where almost everything that had a ticker went up, we will start to see winners and losers standing out more.
We have set our hypothesis for the year and we will act accordingly. I will be looking for strong brands in consumer goods like Nike (NKE), Tapestry (TPR), Apple (AAPL) and Adidas (OTCQX:ADDYY). Retailers in great shape like Amazon (AMZN) and Alibaba (BABA) are also on my list.
Financial companies like Visa (V) that are correlated well with consumer spending should also perform positively if WH1 and WH2 materialize.
A word of caution is warranted. Investors should keep focused on market action and indicators that validate or falsify the working hypothesis above, and they should act accordingly. Many times, I have seen investors seeing their expectations going astray and just sitting, wishing for things to be different. Don't do it. Act as soon as you have evidence, that's why we try to frame the year in advance.
The previous words were a rosy description of a reality that tends to play tricks on you. Most likely, some of the expectations won't materialize, and next year I'll be here trying to explain what went wrong. However, if the market retains its winning streak, we must keep in mind that it won't last forever. Some of the supporting factors right now might become the reason of the next fall. Therefore, let's see one hypothesis for the post-2018:
Catastrophic Hypothesis - Economic expansion through stimulus at a time when the economy doesn't seem to need them, will end in tears.
2018 should be another positive year in the bull market of a lifetime. US internal policies point towards fiscal stimulus and we might also speculate about a possible infrastructure plan. The earnings repatriation, coupled with fiscal savings from the companies will add to the investment flow. The low unemployment rate coupled with incremental fiscal savings should allow the consumers to increase spending. Most likely, corporate earnings should grow in a self-reinforcing fashion, just like the US sovereign debt.
Sometime soon, this will come back to haunt us. Be it through rising interest rates that halt investment and cool the economy, or because of supply miscalculations (companies expanding too much), or something else, it will comeback in some karmic fashion.
My advice is to navigate this late bull market like it was the last party ever. Take the most out of it, but be prepared for the winter, because the winter always comes.
Disclosure: I am/we are long V, AMZN, NVDA, ADBE, ISRG, TPR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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