Equity Strategy

Timely discussion of recent equity market action with equity sector highlights and what it may mean for investors.

January 18, 2018

Stuart Freeman, CFA, Co-Head of Global Equity Strategy

The Meaning of Dow 26,000

  • The Dow Jones Industrial Average crossed 26,000 for the first time this week, but we attribute little to the milestone.
  • Solid equity-market fundamentals support positive 2018 equity returns, but full valuations and recent narrow market leadership suggest that the gains may come with more potential price swings.

What it may mean for investors

  • With this backdrop, we reiterate our specific equity recommendations in today’s report.

Download the report (PDF)

Keep perspective: Dow Jones Industrial Average “1,000 marks” have limited meaning

Since early 2017, we have watched the Dow Jones Industrial Average (Dow) click past successive 1,000-point intervals, between 20,000 and 25,000. In previous times, we have been able to celebrate such milestones only occasionally. However, it is critical to keep in mind that 1,000-point moves in the Dow represent smaller and smaller percentage increases as the Dow moves to higher levels. For example, the 50% move between 2,000 and 3,000 took 39 months (see the table below), but the move between 25,000 and 26,000 was only 4% and occurred in only 12 calendar days.

Dow 1000-point milestones mark percentage gains of decreasing importanceDow 1000-point milestones mark percentage gains of decreasing importanceSources: Bloomberg and Wells Fargo Investment Institute, January 16, 2018.
The Dow Jones Industrial Average is an unweighted index of 30 “blue-chip” industrial U.S. stocks. An index is unmanaged and not available for direct investment.

Solid fundamentals are driving the rally, but volatility risks are rising

Fundamentals are still driving the equity markets, and new highs are possible later this year. But the path higher may not be as smooth as it was in 2017.

There are several key factors contributing to the favorable fundamental backdrop:

  • The improving economy and the tax overhaul should drive stronger domestic corporate revenue and earnings growth. We do not currently see the signs for recession in 2018.
  • We expect inflation to trend mildly higher in 2018—consistent with moderately higher bond yields. This still is a benign factor for equity prices.
  • Current exchange rates put the dollar in a weaker position than was the case a year ago, and this supports earnings for multinationals. Looking ahead, crosscurrents around the dollar should prevent strong depreciation or appreciation from today’s levels.
  • Institutional investors, corporations, and households still hold significant cash positions that are available to support equity markets.

But 2018 equity gains are unlikely to be as steady as they were in 2017:

  • The equity rally has been narrow. Only 17% of S&P 500 Index constituents (85 companies) accounted for roughly 79% of the index’s gain last year. Twenty-three of those constituents came from the Information Technology sector, which also led the other sectors with 37.4% of the index’s 2017 total return. We consider that dominant share of return to be a volatility risk in 2018, as investors take profits or rebalance portfolios.
  • Absolute valuations are extended above their historical medians, and that remains a risk for domestic equity price swings this year. The last S&P 500 Index pullback of 3% was more than 380 days ago.

Yet, the market’s fundamental outlook does not suggest a bubble:

  • Although we have come off of a strong year for equity returns overall, fundamental factors do not suggest that domestic equity markets are currently in bubble territory. In fact, looking back to 1970, when the S&P 500 Index had increased by 18.5-22.5% over the course of a year (it is up roughly 20.7% over the past 12 months), the index has moved higher in the following year 75% of the time, with a median 12% increase. It has declined 25% of the time with a median decline of 10% over the next year. Out of the 40 instances, 2 of the 10 instances of forward 12-month declines were related to recessionary periods.

What to watch as the year progresses

Our base case is a favorable equity outlook, but we will remain vigilant for changing risks:

  • If tax reform encourages additional capital spending, employment, and growth, and if inflation remains benign, then tax cuts might postpone the typical late-cycle revenue deceleration. The equity outlook could strengthen further.
  • Should forward-looking data and sentiment suggest that the pickup in growth may falter, we might lean less favorably toward cyclical sectors and might turn more defensive on equity markets.
  • If tax reform sparks more household spending without a corresponding increase in productive capacity, then higher inflation could result and, with it, a faster pace of Federal Reserve interest-rate hikes. That scenario might be less constructive for domestic equity markets.

What should investors do now?

We foresee higher equity prices but also full valuations and more potential volatility. With this backdrop, we recommend particular adjustments to equity positions.

  • As improved equity fundamentals no longer justified our previous underweight to U.S. Small-Cap Equities, we upgraded this asset class to evenweight (neutral) in early January. We also reduced U.S. Intermediate-Term Fixed Income from overweight to evenweight, due to slowly rising bond yields on the shorter end of the yield curve (which caused the curve to flatten and reduced the yield pickup from moving to intermediate maturities). We recommend that investors align their portfolios now to match these allocation changes, by raising their U.S. Small Cap Equity exposure to evenweight and by reducing U.S. Intermediate-Term Fixed Income exposure to a neutral (evenweight) position. Both of these tactical adjustments are explained in our January 3 Institute Alert report.
  • We recommend that investors rebalance away from interest-sensitive equity sectors and into growth-focused sectors. We favor reallocating assets away from defensive sectors that tend to underperform when interest rates are rising (Utilities, and Consumer Staples). We also consider the Energy sector to be relatively overvalued today. Instead, we suggest investors lean primarily into sectors that benefit from economic growth and low inflation (such as Consumer Discretionary, Industrials, and Financials). Additionally, we favor the modest growth Health Care sector which offers relatively attractive valuations.
  • We see opportunities to rebalance potential risk and reward. Specifically, over the past six months, equity prices in the U.S. Energy and Information Technology sectors have moved aggressively higher. These stocks may be vulnerable to profit taking if volatility returns. We believe that investors should reduce exposure to underweight in Energy and to evenweight in Information Technology. Any profits could be reallocated toward real estate investment trusts (REITs)—an asset class for which we favor an overweight position.
  • While Information Technology (IT) has been a leader over the past year, we believe that this sector will continue to offer future earnings potential in this cycle. It has largely been playing catchup after market-performing between early 2012 and mid-to-late 2016. Valuations relative to the S&P 500 Index remain midstream, and we suggest an evenweight position. Investors (whose portfolios have become overweighted) may want to reduce IT exposure to evenweight, and they could reallocate cash sequentially throughout 2018. As more historically typical volatility resumes, such a plan offers the potential to reposition holdings at prices below current levels. So-called “dollar cost averaging” also can be used to increase portfolio exposure to equity markets that have been persistently below our target recommendations, including the international developed and emerging markets.

Risk Considerations

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Sector Risks

Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio's vulnerability to any single economic, political or regulatory development affecting the sector. This can result in greater price volatility. Risks associated with the Consumer Discretionary sector include, among others, apparel price deflation due to low-cost entries, high inventory levels and pressure from e-commerce players; reduction in traditional advertising dollars; increasing household debt levels that could limit consumer appetite for discretionary purchases; declining consumer acceptance of new product introductions; and geopolitical uncertainty that could impact consumer sentiment. Consumer staples industries can be significantly affected by competitive pricing particularly with respect to the growth of low-cost emerging market production, government regulation, the performance of overall economy, interest rates, and consumer confidence. The energy sector may be adversely affected by changes in worldwide energy prices, exploration, production spending, government regulation, and changes in exchange rates, depletion of natural resources and risks that arise from extreme weather conditions. Investing in financial services companies will subject a portfolio to adverse economic or regulatory occurrences affecting the sector. Some of the risks associated with investment in the health care sector include competition on branded products, sales erosion due to cheaper alternatives, research & development risk, government regulations and government approval of products anticipated to enter the market. Risks associated with investing in Industrials include the possibility of a worsening in the global economy, acquisition integration risk, operational issues, failure to introduce to market new and innovative products, further weakening in the oil market, potential price wars due to any excesses industry capacity, and a sustained rise in the dollar relative to other currencies. Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market. Utilities are sensitive to changes in interest rates and the securities within the sector can be volatile and may underperform in a slow economy.

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Global Investment Strategy (“GIS”) is a division of Wells Fargo Investment Institute, Inc. (“WFII”). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the GIS division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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