Hiding from volatility? You might be missing out

In many ways, 2017 was an exceptional year. The U.S. equity market did better than most expected, despite concerns about the new President and worries about the economy, valuations, Brexit, North Korea and the Middle East.

Anticipation of pro-business policies (primarily lower taxes and reduced regulation) seemed to increase confidence and provide a mild stimulus to economic activity. Towards year end the momentum appeared to be building and it now seems that the second leg of the bull market – the earnings driven phase – has begun, after a two-year period spent digesting the gains of the first six years of the recovery.

The stock market now seems fairly valued relative to interest rates and, actually, inexpensive compared to some other asset classes. My sense is that equities are under-owned today, following a lengthy period where investors dumped equities in favour of just about anything else where the volatility was considered to be more palatable. In the long run, I believe hiding from volatility is a losing strategy because it ultimately also means sidestepping the potential for higher returns. Volatility is mostly an emotional near-term issue, whereas returns are a long-term reward for good capital allocation.

The most encouraging aspect of 2017 was the broadening of the market and the solid returns from true growth stocks and beneficiaries of enhanced economic activity. This pattern is expected to continue in 2018. The market should move higher in concert with earnings, which are now on track to grow by 15%^†. Rates will likely rise from today’s low level but only modestly as inflation is expected to remain subdued.

In my view, there is risk in some stocks that have moved ahead too fast and now have valuations that appear unwarranted. Some of these are very popular and have perhaps attracted a lot of unsophisticated hot money. Ultimately, there is lots of room for rotation into more modestly valued companies and this type of activity not only reduces risk, but also helps fuel subsequent advances as leadership shifts.

We don’t really understand yet the full implications of the rising allocation of funds to passive vehicles, so this will be something to watch, particularly over the next few years as we move to the latter stages of the bull market when investors typically become less discriminating.

In the near term, we have earnings growth, low equity weights and widespread pessimism in our favour, so we expect another year of decent returns.