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All Contents © 2018The Kiplinger Washington Editors
By Elizabeth Leary, Contributing Editor
| January 5, 2018
The five FAANG stocks – Facebook (FB), Amazon.com (AMZN), Apple (AAPL), Netflix (NFLX) and Google parent Alphabet (GOOGL) – soared to vertiginous heights last year, closing out the year with an average return of 49.12%. That’s in no small part due to the strength of their underlying businesses. But the stocks also rode high on investors’ infatuation last year with growth and tech stocks.
Although it’s possible that 2018 could see a continuation of last year’s trends, we think it’s more likely that other sectors and styles will take the lead. That’s because other asset classes, such as emerging markets and small-company stocks, show more promising value compared with U.S. growth and technology names. That’s also due to certain secular trends, including the current phase of the business cycle and the recently passed tax-reform law, which stand to benefit other asset classes.
Here is a closer look at five investment strategies and fund categories that could rule this year.
Data is as of Jan. 4, unless otherwise noted. Click on ticker-symbol links in each slide for current share prices and more.
Michael Mullaney, director of global market research for Boston Partners, says value-oriented investment strategies are clearly due for a winning stretch. He sees several macroeconomic reasons for this rotation.
Mullaney expects U.S. economic growth to near 3% this year thanks to strong business investment and international demand – even before factoring in the effects of corporate tax cuts. “Historically, when GDP growth has been above 2.5%, value has beaten growth across market capitalizations,” he says. He also anticipates inflation and interest rates rising during 2018 – two factors that have historically boded well for value investing, Mullaney says.
Not to mention, it’s hard to imagine shares of fast-growing companies posting another humdinger of a year on top of last year’s gains. The iShares Russell 1000 Growth ETF (IWF) returned 29.95% last year, compared with 13.45% for the iShares Russell 1000 Value ETF (IWD). The last time growth enjoyed such a large performance gap over value was in 1999, Mullaney says, “just before value went on a six-year winning streak.”
Emerging-markets stocks are coming off a hot year. Funds that invest across developing nations returned 34.31% in 2017, compared with a 21.83% return for Standard & Poor’s 500-stock index. A declining U.S. dollar is at least in part to thank for that strong performance – many emerging nations borrow and repay debt in U.S. dollars, so a weaker dollar translates into easier access to credit.
Many top analysts and banks are predicting 2018 will bring another bad year for the dollar, meaning that fertile environment for emerging markets is likely to continue.
Craig Callahan, founder and president of ICON Advisers, says emerging-markets stocks are also simply attractively valued, even after the big run-up. “Even though stock prices have advanced, they are still below ICON’s estimate of fair value, on average.” His firm’s fair-value estimates are partly based on earnings-growth projections, which analysts continue to revise higher for emerging-markets stocks.
Callahan says shares of companies from China and the Philippines look particularly attractive under his firm’s valuation model.
It’s no secret that big companies formed a winning ticket in 2017. The iShares Russell 1000 ETF (IWB), which tracks the large-company index, posted a 21.53% return last year, trouncing the 14.59% return for the iShares Russell 2000 ETF (IWM), which follows small companies.
But after such a significant performance gap, small caps are due.
Omar Aguilar, chief investment officer of equities and multi-asset strategies for Charles Schwab Investment Management, says that small-cap valuations look attractive on a range of measures – including price-to-earnings and price-to-free cash flow – when comparing today’s valuations against historical ranges. By contrast, he says, large caps are generally expensive on the same measures. Boston Partners’ Mullaney adds that the last time large caps beat small caps by such a wide margin was in 2015, which was followed by a bang-up year for small caps in 2016.
Need one more reason to give small caps a chance? Small companies typically pay higher effective tax rates than large companies, Mullaney says. That means the benefits of the tax-reform law should offer a bigger boost to smaller companies, he says.
Consider this a bearish pick. Although index funds generally beat actively managed funds during bull markets, active funds tend to lead during bear markets, according to research by Dalbar, Inc. More specifically, large-cap funds on average beat their benchmarks in each of the past three bear markets, when measured from peak to trough, according to Fidelity.
That trend is likely due to the fact that active managers tend to incorporate risk-management into their investment approaches, such as by keeping a certain amount of cash on hand or underweighting sectors or individual stocks that they feel are overbought.
Index funds have been riding to glory during the current bull market, which will turn nine years old in March. Over the five years through the end of June, not a single category of actively managed U.S. stock funds has on average beaten peer index funds, according to Morningstar.
But no bull lives forever. If 2018 is the year the aging bull buckles, active funds could finally get a little glory of their own.
The tax overhaul that President Donald Trump signed into law on Dec. 22 could be one of the most significant influences on the market in 2018. While the law’s corporate tax cuts may prove to be a rising tide that lifts all boats, the law in particular contains a major goody for real estate investment trusts.
Thanks to a new deduction for pass-through businesses, investors will now be able to deduct 20% of the dividend income they receive from REITs, even if they don’t itemize deductions. That effectively lowers the tax rate investors pay on REIT income, which should draw more investors into the shares.
Another small bonus for the sector? Capping deductions for state and local taxes – the law limits such deductions to $10,000 per year – may hurt the market for single-family homes. But it could give a boost to REITs that operate multifamily housing.
The real estate sector largely missed out on 2017’s bounty. Funds that invest in real estate returned just 6.21% on average, last year. But if the U.S. economy keeps firing on all cylinders, then the tax law could turn the tide for REITs.
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