Bull Case / Bear Case: Why The Stock Market Will (Or Won’t) Rise In The Second Half of 2018

At the beginning of the year, I wrote that there were equally strong arguments that the stock market would overperform or underperform in 2018. In this article, I’ll take a look at how the stock market has performed so far this year, and make the bull and bear case for the second half of 2018. In doing so, I hope it will again highlight that it is very difficult to predict the future direction of the stock market, and investors would be wise to stick with their asset allocations and not try to time the market.

Asset Class Performance In The First Half of 2018

Here’s how different asset classes have performed thus far in 2018:

[As of 6/27/18. Data source: Morningstar]

While the stock market has had many ups and downs over the first six months of 2018, the overall stock market has eked out a small positive gain: +1.8% for the S&P 500 and +2.5% for the total stock market. International has underperformed U.S. stocks, and bonds have slightly declined. The big winner so far this year has been oil, although it notably has been one of the worst performers in previous years.

Some investors like to tilt their portfolio towards small-cap or value stocks — so far this year, small-cap stocks have outperformed the total stock market, while value stocks have underperformed.

2018 Themes So Far

There have been several overarching themes that have driven stock prices so far in 2018. These market forces have largely canceled each other out, leading to the roughly flat performance of the stock market:

The U.S. economy remains strong

Economic and job growth in the United States remain strong. U.S. GDP grew by 2% year-over-year in the first quarter of 2018. The U.S. economy added over 1 million jobs in the first 5 months of 2018, and employment is currently at an 18-year low at 3.8%.

The U.S. is engaged in a trade war with the rest of the world

Donald Trump’s administration is currently engaged in a trade war with China and many of its other trading partners around the world. Since the stock market prices in not just past economic performance but also projected future performance, stock market gains have been limited by fears that a decline in international trade will eventually hurt the U.S. economy.

An unexpected thaw in U.S. – North Korea relations

At the beginning of the year, I wrote that geopolitical concerns, such as the saber-rattling between Donald Trump and Kim Jong Un, could hurt the stock market. Over the course of just a few months, we went from Donald Trump and Kim Jong Un exchanging threats and insults to the pair smiling and shaking hands at a diplomatic summit in Singapore.

The Bull Case For The Second Half of 2018

1. Continued U.S. economic growth — if the economy continues to grow with sub-4% unemployment and create more than 200,000 new jobs every month, the stock market will likely do well.
2. Tax cuts start kicking in — even though Americans have not filled out their 2018 taxes, they likely are already keeping more of their paycheck because of less withholding.
3. Trade war ends — economists fear that curtailing international trade through tariffs hurts both sides. An end to the trade war would remove one of the headwinds currently facing the market.
4. Republican gains in the midterm elections — in general, Republicans support pro-business policies that would boost the stock market. While many political watchers believe that Democrats could take the House in 2018, if Republicans can retain their House majority (and expand their Senate majority), then additional pro-business policies could be passed in 2019.

The Bear Case For The Second Half of 2018

1. Valuations finally catch up with the stock market — The Case-Shiller PE10 ratio remains at levels not seen since the Internet tech bubble of the 1990s, leading many market observers to believe that a correction is coming.
2. The U.S. economy slows — some market watchers believe we are at the end of this current economic cycle and are due for a recession.
3. Trade war continues to escalate — how the trade war plays out between the U.S., China, and other nations will drive the stock market in the coming months. Stock market bears believe that Donald Trump will continue his “America First” policy to fulfill a campaign promise and motivate his supporters in the midterm elections.
4. Something unexpected occurs — The market hates uncertainty, and Donald Trump brings a lot of uncertainty into the world.

Conclusion

Predicting the short-term future direction of the stock market is challenging. Even if you can make a strong case for or against the stock market rising in the future, new events can occur that are difficult to predict in advance. The unexpected warming of relations between the U.S. and North Korea, as well as the escalating trade war between the U.S. and the rest of the world are examples of market-moving changes that were not on my radar screen at the beginning of 2018.

Market watchers continue to make bold predictions about the future direction of the stock market. However, I believe that the current price of the stock market builds in all of the factors that could cause the market to rise or fall in the future. Rather than bet on the short-term direction of the stock market, you should instead consistently bet that the long-term direction of the stock market is up.

What do you think? Do you think we are nearing the end of the current bull market cycle? Have you shifted your asset allocation in any way since the start of the year?