Vanguard Sounds Alarm on the 2018 Stock Market

Vanguard just released a dour research note on prospects for the 2018 stock market, citing higher interest rates, increased inflation, and stronger market volatility at the center of its argument.

It’s must reading for investment advisors.

“In an environment in which consensus expectations have finally centered on a long-term outlook characterized by tepid growth and inflation, there is risk that a cyclical rebound in economic fundamentals could cause a market repricing,” said the note, “Volatility and Inflation May Disrupt Status Quo In 2018.”

U.S. investors should be worried that a wage or inflation hike could lead markets to reprice a more aggressive path of policy rate normalization by the Federal Reserve. That would end a long period of low volatility, the note said.

For years, forces of globalization, demographics, and technology served as the foundation for Vanguard’s long-term outlook of modest growth and tepid inflation, said Joseph Davis, Vanguard global chief economist.

“As we head into 2018, investors should not mistake these secular trends for short-term cycles,” he added. “Instead, we anticipate a bit more volatility and an uptick in inflation in the year ahead, accompanied by more muted equity returns.”

In fact, Vanguard said its outlook for global stock and bonds is the “most subdued it has been in a decade.”

“Elevated equity valuations, low interest rates, and compressed spreads have pulled the market’s efficient frontier into a lower orbit,” the note said.

Key Vanguard predictions include:

* “In the U.S., equity returns are expected to hover in the 3-to-5 percent range, in stark contrast to the 10 percent annualized return generated over the last 30 years.”
* “Non-U.S. equity markets could see returns closer to the 5.5-7.5 percent range, emphasizing the benefits of a globally diversified portfolio in the years ahead.”
* “The return forecast for fixed income is positive but muted in the 2-to-3 percent range for the next decade.”

More Volatility Expected

The Vanguard outlook mirrors a fresh set of data from Boston-based Natixis Investment Managers, which recently polled 500 professional investors who manage more than $19 trillion of assets for retirees, governments, insurance companies and other institutions.

Here are some takeaways from the Natixis study:

More volatility: Seventy-two percent of respondents are surprised that volatility has been so low for so long, but don’t think that trend will continue in 2018. Seventy-eight percent expect the stock market will be more volatile and 70 percent think the bond market will be more volatile next year.

Bubbles: Thirty percent of respondents fear there is a stock market bubble and 42 percent believe there is a bond market bubble, while 71 percent say that both institutional and individual investors are assuming too much risk in pursuit of yield.

Biggest threats: Geopolitical events (such as North Korea) were seen as the greatest market threats. Next were asset bubbles and an increase in interest rates.

Active management gains favor: Seventy-six percent of respondents say 2018 will be more favorable for active management than passive management.

Sector picks for 2018: Technology (45 percent), healthcare (44 percent), and defense/ aerospace (43 percent) are predicted to outperform the market is 2018.

Alternatives rule: The biggest moves in the year ahead will be increased allocations to non-traditional assets, including private equity, private debt, real estate and infrastructure.

“Investors are facing unprecedented challenges as central banks unwind the easy money policies that have dominated the markets since the financial crisis and prepare for the first challenging bond market in more than a generation,” said David Giunta, chief executive officer for the U.S./Canada at Natixis Investment Managers.

'Hard Not to be Nervous'

Professional money managers are in general agreement that investors face fairly stiff headwinds heading into 2018.

“It's hard not to be nervous about this market going forward,” said Dan Thompson, owner and founder of Wise Money Tools.

When analyzing what 2018 could bring to the table for investors, Thompson said he’s eyeballing a few key indicators.

“The first issue is the Schiller price-to-earnings ratio, where the median ratio is about 16,” he said. “All-time highs of the ratio occurred during the internet boom of the late 90's when all fear and caution was thrown to the wind chasing after the next big internet stock. That took the Schiller PE ratio to 45 - the highest ever.”

Just before the 2008 crash occurred the PE ratio soared to 27, Thompson added. As of December, it stood at 31.90.

“This would be an all-time high if you take out the Internet bubble,” he said.

The other indicator Thompson is tracking is commonly referred to as the “Buffet Ratio.”

“It's essentially market cap over gross domestic product - that gives you the ratio,” he explained. “A ratio of 75-90 percent says the market is valued about right. A ratio of 90-115 percent is modestly overvalued and anything over 115 percent is significantly overvalued. Today we sit at 139 percent. There is no term for this high of a ratio, so I call it ‘extremely overvalued.’”

That would trigger a bad-news, good-news scenario for investors next year.

“The bad news is that we are due for some kind of pull-back, correction, or bubble-burst,” Thompson said. “The good news is for value investors and those waiting on the sidelines for stocks to go on sale, we may see that in 2018.”

Given higher valuations in U.S. stocks and a likely market return of anywhere from 0-to-4 percent next year, some investment experts advise looking overseas.

“For long-term-only investors, make sure you’re globally diversified,” said David Taggart, a trading expert at Process Driven Macro, a global investment strategy services provider.

“If someone is putting money into their 401(k) or other investment account, their contributions should be steered into the cheap markets right now.”

Emerging Europe, emerging markets, and developed Europe are the cheapest places these days, Taggart said, and most U.S. investors have very little exposure to them.

“If you want a safer and better portfolio, then start allocating some money into these areas,” he said. “Most investors should bump up their allocations to foreign stocks by 10-30 percent. The range is so wide because so many have a zero percent allocation right now.”

Also, diversifying bond allocations is a good idea, too.

“Government debt the world over is not exactly cheap, so investors might want to start picking up some emerging market debt, and some global debt,” Taggart said. “I wouldn't go heavy here, but if you currently have a 0-to-5 percent allocation, maybe bump it up by 5-10 percent.”

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms. Brian may be contacted at [email protected].

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