Why The Stock Market Will Underperform in 2018

The stock market had an amazing 2017, with the S&P 500 rising 21.8%.

In my last post, I made the argument that the good times will continue and the stock market will overperform in 2018. However, don’t rush out and be 100% equities. An equally strong case can be made that the stock market will underperform in 2018.

1. We’re due for a correction.

The bull market is now 9 years long, and many people have been predicting a stock market correction for many years. The stock market never fell more than 4% in all of 2017, so a correction, even if temporary, could happen in 2018.

2. Valuations are too high

The Shiller P/E 10 ratio, a popular metric for stock market valuations, is now at its second-highest level on record. The only period when it has been higher was during the internet tech stock bubble in the late 1990s.

We all know how that ended, and 2018 is as good a year as any for the bubble to burst.

3. Investors are too exuberant about stocks

You can see the complacency in investors regarding the stock market and investing. There is little fear in the stock market. The VIX, a metric of stock market volatility, is at an all-time low.

In general, the stock market experiences long periods of relatively smooth growth, followed by fast corrections or bear market. As anesthesiologists might say, “it’s hours of sheer boredom followed by seconds of pure terror.”

4. The tax cut will hurt the economy

Most Americans and corporations will have more money in their pockets because of the tax cut, but this is at the expense of decreased government revenue. The tax bill is projected to cost over $1 trillion dollars over a decade.

While Donald Trump and the Republicans believe that their tax cut will create jobs and further boost the economy, many economists and Democrats are skeptical that it will be able to live up to the hype.

5. Buy the rumor and sell the news

There’s an old trading adage to “buy the rumor and sell the news.” The stock market has risen significantly since Donald Trump’s election in anticipation of pro-business policies and a large corporate tax cut. Now that the tax cut has been delivered, investors may realize that the tax cut wasn’t as great as they had anticipated and the stock market will fall.

6. The Federal Reserve will raise interest rates

With the economy going strong, the Federal Reserve may be eager to raise interest rates and reverse the stimulus it provided to help the U.S. economy get through the financial crisis.

This has the potential to slow economic growth and reduce corporate profits, hurting the economy.

7. Democrats are poised to take control of Congress

Donald Trump’s approval ratings are at historic lows, and all political signs indicate that the Democrats will make gains in the House and potentially the Senate. If Democrats control either chamber after the 2018 midterm elections, much of Donald Trump’s pro-business agenda will grind to a halt. This could lead to stock market underperformance.

8. Geopolitical risks remain, especially with Donald Trump as president

The stock market hates uncertainty. And there are many potential sources of uncertainty in the stock market going into 2018.

North Korea continues to work on its nuclear program in spite of U.N. sanctions. There is much saber-rattling between Donald Trump and Kim Jong Un. While the stock market has largely shrugged off the rhetoric between the two leaders, a further escalation in tensions could spur a stock market decline.

The investigation of Russian interference in the 2016 U.S. presidential election continues, and a bombshell report from Robert Mueller’s special counsel could be released in 2018. While it is unlikely that Donald Trump would be impeached by a Republican Congress, political instability could hamper stock market returns in 2018.

Conclusion

There are several common themes between the bull market and bear market cases for 2018. Depending on your views on current stock market valuations, the effects of the tax cut on the U.S. economy, and the relative risk of geopolitical tensions, you could be bullish or bearish on the stock market.

However, the markets have priced all of the reasons I have mentioned in the previous two posts into its current price. Stick with your current asset allocation for 2018, and continue to invest a part of each paycheck into the market. Turn off the financial news and minimize how often you check your investment accounts. You’re investing for the long-term, not for 2018.

What do you think? Will the stock market overperform or underperform in 2018? Are you taking money off the table in anticipation of a correction?

[Charts courtesy of StockCharts.com]