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After strong year, stock prices have hit lofty levels


(St. Louis Post Dispatch) 

“We come to the conclusion that the market is slightly overvalued for the first time in almost nine years,” says Ken Crawford, senior portfolio manager at Argent Capital Management.

December 31, 2017 (David Nicklaus)

With a big tax cut, global economic growth and continued low interest rates, the stock market found a lot to like about 2017.

The trouble is, the good news will be hard to repeat. Congress is likely to turn its attention from taxes to less popular issues, like the national debt. Interest rates are likely to rise.

Meanwhile, stock prices have risen to lofty levels. With this year’s 21.8 percent gain in the Standard & Poor’s 500 index, including dividends, the market has posted double-digit returns in seven of the past nine years.

Don’t get used to such prosperity, counsels Kate Warne, investment strategist at Edward Jones. “We actually think things look pretty good for next year,” she said. “Our concern is people may be expecting the amount of return they saw this year. We think investors need to be prepared for a bit more of a bumpy ride.”

According to FactSet, investors are paying more than $18 for every dollar the S&P 500 companies are expected to earn next year, well above the 10-year average of $14.

“We come to the conclusion that the market is slightly overvalued for the first time in almost nine years,” says Ken Crawford, senior portfolio manager at Argent Capital Management.

“We would expect returns on the low end of normal going forward.”

Investors do have some things going for them next year.

Even though markets have anticipated the broad benefits of a corporate tax cut, individual companies could get a boost when they update their earnings guidance to reflect lower tax rates.

Look for small companies, with mostly domestic operations, to be the biggest beneficiaries, Warne suggests.

As tax rates fall, though, interest rates are likely to be rising. That hurts stocks in two ways: Companies’ borrowing costs rise, and bonds become a more attractive alternative to stocks.

Joe Terril, president of Terril & Co. in Sunset Hills, is avoiding utility stocks, which are especially sensitive to rate increases. He thinks financial companies, which can benefit from rising rates, are a better bet.

Terril has also turned bearish on stocks in general. “Investment markets are ignoring the fact that interest rates and inflation are going higher,” he says. “I think the surprise is going to be how fast inflation will go up.”

Price increases have accelerated recently in Britain and India, and Terril thinks the U.S. could be next. If inflation goes above the Federal Reserve’s 2 percent target, the central bank might be forced to raise rates faster than investors are expecting.

A surge in wages and material costs also would cut into corporate profits. “At some point, the market will begin to worry about these things,” Terril says. “Right now it’s ignoring them.”

Inflation has been below the Fed’s target for so long that it doesn’t rank high on other investors’ worry lists. “Expectations matter,” says Bill O’Grady, chief market strategist at Confluence Investment Management. “People just don’t expect inflation to become a problem, so it hasn’t.”

O’Grady says a speculative frenzy in stocks worries him more than an imminent crash. “Long bull markets rarely end in a whimper,” he said. “They usually end in a crescendo. I’m more concerned about an unsustainable rise than a rapid fall.”

We’re not in the crescendo phase yet, he added, but another 20 percent jump might put us there.

If 2018’s returns end up looking paltry next to 2017’s, some people will be disappointed. In the context of a long bull market, however, it may be time for a pause that refreshes.