Could 2018 surprise with the same outsized gains as 2017?

Tourists take a picture with the market bull near the New York Stock Exchange (NYSE) on December 8, 2016 in New York City.

Will 2018 be a more “normal” year? 2017 was a year of surprises, but for 2018, not surprisingly, things are expected to be more, well, normal.

Which is why you should be suspicious.

It’s true — by almost all measures, 2017 was one of the most extraordinary years in the history of the stock market. Investors saw:

  1. Extraordinary returns far above the norm. The S&P 500 is up nearly 20 percent this year, far above the roughly 8 percent average yearly gains since 1945.
  2. Extraordinary new highs. We hit 62 daily all-time highs this year, far above the average of 29 that have occurred in years when at least one new high was reached, according to CFRA.
  3. Extraordinarily low volatility. The S&P moved 1 percent or more on only eight trading days this year; the average since 1945 was 50 days.
  4. Extraordinary sector dispersion. The top-performing sector — technology, up 38 percent —outperformed the worst-performing sectors (energy and telecom, down about 5 percent) by more than 43 percentage points.

What does all this mean? The stock market is a numbers game with a long track record. When you get numbers that are way out of the ordinary, it’s logical to believe in mean reversion, that it is highly unlikely that returns or volatility will come anywhere near 2017.

That is exactly veteran market watcher Sam Stovall’s advice to his clients. Stovall is chief equity strategist at CFRA, and in a note to clients advised that investors “would be better off anticipating an increase in volatility, a reduction in new highs, as well as a below-average price gain for the ‘500’ in the year ahead.”

Getting these extraordinary numbers tends to pull forward stock market performance. In years with above-average new highs and below-average volatility (exactly what we had in 2017), the S&P rose the following year only 55 percent of the time, with an average gain of only 3.1 percent, Stovall noted.

In years where the “dispersion” between the best- and worst-performing sectors was high (also what we saw in 2017), the S&P 500 was also up only 57 percent of the time in the following year, with an average gain of only 1.9 percent.

Stovall’s conclusion: “As a result, one could say that in 2018 investors should expect more for less — more volatility for less return.”

Get it? “Less surprise” is a big theme for 2018. Jim Paulsen, chief investment strategist for Leuthold Group, has noted that a good part of the stock markets’ gain has been related to the string of strong economic numbers that we have seen recently: He notes that the U.S. economic surprise index rose to a 6-year high last week.

“Even if the recovery remains healthy in 2018, it can’t continue to surprise,” Paulsen says.

But why can’t it continue to surprise? Peter Tchir, macro strategist for Academy Securities, is not so impressed with the “reversion to the mean” story.

Tchir notes that the global economic expansion continues, that earnings remain at record highs, and the tax cuts are pushing those numbers up: “It doesn’t feel like the tax cut is being fully priced in, and there’s no reason corporate America can’t keep issuing debt and buying back stock. I’m not sure we can’t have more of the same.”

And absent some outside shock, why can’t volatility remain low, he asks. “With ETFs, people have less need to chase daily trading, and I think that’s a good part of the reason why we have seen reduced volatility.”

Bottom line: Reversion to the mean does eventually happen, but we are in very unusual times.

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