The perfect year is over, even if it ended on a note of imperfection.
The Dow Jones Industrial Average fell 34.84 points, or 0.1%, to 24,719.22 last week, not big deal. But the Standard & Poor’s 500 index fell 0.4%, to 2673.61, and the Nasdaq Composite dropped 0.8%, to 6903.39, their largest weekly declines since Sept. 8.
Despite ending on a sour note, it’s hard to argue that the year could have gone much better. The Nasdaq finished up 28% in 2017, while the Dow gained 25%, and the S&P 500 rose 19%. And the S&P 500 even managed to finish in positive territory each month on a total return basis—the first time that has ever happened. “You don’t get an easier year than that,” says Michael Shaoul, CEO of Marketfield Asset Management. As we said: perfect.
Following perfection is rarely easy, though the market has been pretty good at responding to big gains with more of the same. Including reinvested dividends, the S&P 500 has returned 20% or more 26 times since 1943, and followed that up with another positive year 20 times, says Sadoff Investment Management. The average return following a 20% gain has been 12%. But four of the six down years—1962, 1981, 1990, and 2000—had one thing in common: The Federal Reserve was “dramatically tightening credit,” Sadoff says.
While no one would describe the Fed’s current tightening as “dramatic,” it has been raising interest rates and would like to raise them a few times more next year. The market isn’t buying it yet, especially as inflation remains so low. But some assets are close to levels that may force investors to rethink their expectations, says Jim Paulsen, Leuthold Group chief investment strategist. He notes that the U.S. Dollar Index is approaching a three-year low—it closed down 9.7% in 2017 after declining 1.1% last week—while the 10-year Treasury yield closed the year at 2.41%, just 0.2 percentage point away from a three-year high of its own.
Even oil managed to close the year at its highest level in 2½ years. If they all break out, especially if they do so simultaneously, more inflation could be building than the market expects, and that would force investors to reconsider whether they want to pay 18 times forward earnings for the S&P 500, Paulsen says. “This year felt like a sweet spot,” he continues. “The question is whether that sweet spot can persist.”
What should we hope for? Not another 2017, says Jason Pride, director of investment strategy at Glenmede. With valuations as high as they are, another year of big gains could stretch them even more, even to levels that trigger a selloff. “We’d prefer to see 2018 be tamer for the market,” he says.
As if we have a choice in the matter.