After solid gains in 2017 technology stocks have continued to lead the way in 2018. However, the enthusiasm for growth stocks isn’t what it used to be. The return of the VIX in February reminded investors that gains equities do not come without risk.1 Despite the return of more volatile markets, the bullish trend has still favored growth stocks. The most notable have been information technology stocks since the beginning of the year. Year to date the Nasdaq has gained 6.4% while the overall S&P 500 has gained 1.47%.2,3 But is it time for new leadership to emerge to shepherd this market to new heights?
Part of the argument for a change in the leadership of the trade lies in the doctrine of economic cycles. General economic theory suggests that in the middle stage of an economic expansion, which we define as moderate inflation, interest rates and capacity utilization, is where base materials and technology firms, also known as growth stocks, tend to do very well. This has tended to be true in the recent past as base material stocks recovered well in 2016 and the expansion in technology stocks has been remarkable over the last couple of years. In the late stage of the cycle, which is defined as a period of rising interest rates and a flattening yield curve, energy and services companies such as financial have historically been very profitable.4 Stocks in these sectors are typically known as value plays. Recent trends are suggesting that we are leaving the middle stage and entering the late stage which may account for the some of the recent volatility seen in the overall equity markets in the month of February.
Supporting the argument that we may well be at the end of the middle stage and entering the late stage lies in the earnings growth forecasts for 2018. While the consensus for growth in earnings on the S&P 500 is an eye popping 17%, the sectors that are expected to lead the pack are energy, materials, information technology and financials. Interestingly the greatest change in earnings growth expectation versus a year ago belongs to the energy sector which has been known to do well in the beginning of the late stage of an economic recovery. Following the recovery in the price of crude oil, as measured by west Texas intermediary (WTI), earnings for the combined 11 subsectors are expected to grow by 82.3% in 2018.5 This could translate itself nicely into gains for patient investors.
Another consideration is the tremendous run that some of the largest US tech firms have enjoyed. Apple, Microsoft, Facebook, Amazon and Google accounted for a quarter of the return of the S&P 500 in 2017. These firms have done a spectacular job of growing their businesses around the globe and their profits growth is a testament to their success in doing so. This aspect has not been lost on governments outside the United States and some are looking to take steps to get their share of the tax revenues. Several European Union (EU) member states are locked in court battles with these companies. They argue that global tech companies pay less than half of the taxes that that traditional brick and mortar EU businesses do, yet they are allowed compete in their markets with impunity.6,7 Challenges of this sort tend to happen when sectors do well and is rarely rewarding for shareholders until these matters shake out. We do not have to look too far back to remember the royalty increases for energy firms in Alberta back in 2007 when WTI was reaching all-time highs.8
All things considered the US stock market should produce gains for investors in 2018 given the earnings growth momentum across the various sectors on top of the tax reform recently legislated. Once new leaders congruent with the present market cycle emerge, investors could be richly rewarded for their patience and discipline.
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