Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: The Fed announced Wednesday that it will raise rates in December, as expected, and maintains its forecast of three hikes in 2018. It also said it would accelerate the unwinding of its massive balance sheet going forward. Considering this was most likely the last significant policy move led by Fed Chair Janet Yellen, what are your thoughts on the Fed’s role and potential impact on the market as we head into next year?

Stovall: Well, certainly the Fed is going to be an important aspect to trading in 2018 because they are likely to be raising rates three more times. But I don’t think they are going to be the dominant issue. Certainly, as we head into the new year, the question of whether we end up with a tax cut will be very, very important, as well as what kind of impact that will have on corporate earnings and overall economic growth.

Off to the side will be the Fed’s activities. The only thing that does raise a question is the amount by which the Fed will be accelerating its quantitative tightening—in other words, the unwinding of its balance sheet. It will depend on how much they do plan on doing and how quickly, but other than that, I think that the Fed’s actions have already been built into equity prices.

EQ: Speaking of 2018, in this week’s Sector Watch, you laid out CFRA’s outlook for next year. From a high level, you described expectations are for a good, but not necessarily great year for the market. Can you elaborate on those expectations?

Stovall: First off, 2017 was a remarkable year because we had 60 times in which the S&P 500 set a new all-time high, combined with only eight times that the S&P 500 was up or down by 1% or more in a single day. Whenever we have had a high number of new highs and a low volatility count, the average price change has been similar to where we are today—near 20%—but the question is whether that steals from potential price gains in the subsequent year.

Well, history says yes. While we still end up with a positive year on average, the gain is closer to 5% than the near-20% that we typically see during favorable all-time highs and low volatility years. At the same time, we find that the frequency with which the market has risen has gone down following those very special years. Therefore, I still think it’s going to be a good year, but not a great year.

Also, our price target for the end of 2018 is 2,800 on the S&P 500, which would point to a single-digit price appreciation, but that’s with the assumption that we end up with even stronger earnings growth than Wall Street is expecting right now. So, I think we’d have to be optimistic even to assume that we end up with a mid-single-digit price gain in the coming 12 months.

EQ: Even with that muted expectation, in terms of portfolio allocation, you noted that stocks will remain the asset of choice. But considering elevated valuations and a pro-longed run without a digestion of gains, how aggressive should investors be toward equities, both domestically and foreign?

Stovall: Certainly, with domestic equities, I don’t think investors should be overly aggressive, because let’s face it, in only a couple of months we’ll be celebrating our ninth birthday of this bull market. Remember, only one other bull market lasted that long. We’re also in the second-most expensive bull market since World War II, and even with elevated expectations for earnings growth, we can only point to a single-digit price appreciation. So, I think while equities remain the asset class of choice in a rising interest rate environment, I don’t think investors should get overly optimistic.

We do have an overweight recommendation to international equities, where valuations and dividends are much more attractive. With that said, I think the old adage of, “if the US sneezes, the rest of the world catches a cold” still holds true. Should we fall into a correction or bear market here in the US, I don’t think international equities will be immune.

EQ: In terms of sectors, you reiterated that cyclical groups should continue to outperform defensive groups. Are there any particular sectors that are expected to stand out in the anticipated environment for next year?

Stovall: Yes, we currently have overweight recommendations on Industrials, Materials, Health Care and Financials. I think that Financials is likely to be among the better performers, first off, because as the Fed goes through the unwinding of its balance sheet, that will allow the yield on the 10-year note to rise, which will steepen the yield curve, and therefore make it more profitable for banks, who can borrow at a lower rate and lend at a higher rate.

If we do end up with an improvement in economic growth, combined with the possibility for infrastructure spending, then that will benefit the Industrials and Materials. Also, we’re in the seasonally favorable period for the cyclical sectors in general, and the Industrials and Materials, in particular. It’s the reverse of the adage, “sell in May and go away,” in which the defensive sectors tend to do better, but it’s the cyclical sectors that do best from November through April, particularly Industrials and Materials.

We also have an overweight on Health Care, but we think that, in a descending scale, that Financials, Industrials and Materials offer the better opportunities in the coming six to 12 months.

EQ: Technology, which has been the clear leader during this bull run, is rated at marketweight for 2018. Is this sector’s remarkable run showing signs of topping out?

Stovall: Not necessarily a topping out, but rather the belief is that maybe Technology has already had its day in the sun. Technology stocks have by far been among the better performers. On a year-to-date basis, we have seen Technology stocks up more than 30%, as compared with a sub-20% gain for the S&P 500. So, I think Technology is, in a sense, starting to take a back seat, but it doesn’t necessarily mean they will go through a corrective phase. Earnings are expected to be up by about 11%, which is very similar to the S&P 500 in 2018. The P/E ratio for Technology is also very similar to the S&P 500, so we have a marketweight rating on the group, but we certainly don’t think investors should be selling their Technology shares. Just be aware that they will probably end up being market performers.