Where to invest now: Our midyear outlook for 2018

By Anne Kates Smith, Follow Kiplinger

Our forecast: Higher stock prices by year-end, with continued volatility and a slight chance of worrisome headwinds.

If the bull market that began in March 2009 remains intact through August, it will become the longest on record, at least going back to 1932. So it's time for investors to repeat this mantra: Age is just a number. We think the stock market will finish the year strong as it emerges from the correction--defined as a loss of between 10% and 20%--that marked the start of 2018. Standard & Poor's 500-stock index is still down about 6% from its January peak.

As always, there are plenty of challenges to worry about. What's different now is that investors have started to worry about them--so look for continued volatility as moods swing on Wall Street. "I'm not bearish, but the risks are growing," says Kristina Hooper, global market strategist at Invesco. It's more important than ever to be on the alert for everything from rising inflation to increasing protectionism to political angst in advance of the U.S. midterm elections.

Characteristically, this bull is aging on its own terms, and strategies that worked at comparable periods in past markets aren't appropriate now. But investors who choose investments wisely in this late-stage (but not end-stage) bull market should prosper. Because it's the season, consider a baseball analogy: We may be into--or even past--the seventh-inning stretch. But fans who leave the game early risk missing some of the best plays.

In our January outlook we forecast an 8% return for the year, including dividends--and investors have earned 6.2% so far. Although we rightly factored a market correction into our forecast, we could not incorporate the impact of the new tax law because it wasn't yet a done deal. With tax cuts now on the books and corporate earnings getting a boost as a result, and with the global economy soldiering on, we are raising our year-end forecast. Expect the S&P 500 to finish the year at 2900 or a bit higher, equivalent to about 26,500 for the Dow Jones industrial average. That's roughly a 7% to 8% price increase from here, and about a 15% total return for the year, including almost two percentage points from dividends. (Prices and returns in this article are through May 18.)
An Economic Milestone

Like the bull market, the economic expansion is also in its 10th year and in June 2019 will tie the record 10-year boom from 1991 to 2001. It's not surprising that market watchers are on the lookout for signs of a slowdown, given that most bear markets are associated with recessions. (Market tops precede recessions by seven to eight months, on average.) But the enormous fiscal stimulus of lower tax rates and increased government spending--some $800 billion in 2018, according to Strategas Research Partners--has given the economy a shot in the arm, inoculating it for now against ill effects from rising oil prices, trade tariffs, higher interest rates and other negative surprises.

Economic indicators with the best records for predicting recessions, including initial unemployment claims, auto sales and industrial production, are far from levels seen at the start of the previous seven recessions, according to a Bank of America analysis. Economists at Goldman Sachs assign only a 5% probability of recession within the next 12 months and only a 34% probability during the next three years. "My working hypothesis now is that the expansion continues as far as the eye can see," says economist and strategist Ed Yardeni. Kiplinger expects economic growth of 2.9% in 2018, up from 2.3% in 2017, and the unemployment rate to finish the year at 3.8%--which would be the lowest rate since April 2000, when 'NSync ruled the airwaves and Erin Brockovich was a top-grossing film.

An economic red flag that spooked the market earlier this year looks like a false alarm for now, but it bears watching. A narrowing of the gap between yields of short-term and long-term bonds, known as a flattening of the yield curve, can signal the kind of aggressive Federal Reserve tightening that can choke off economic growth. An inverted yield curve, which occurs when short rates are higher than long-term rates, has been a reliable sign of impending recession. But short yields must actually edge their long-term counterparts before a recession warning materializes, and we're not there yet, with two-year Treasury notes yielding 2.6% and 10-year notes topping 3%.

Make no mistake, however: The Fed is committed to raising short-term rates this year and next to keep a lid on inflation. Commodity prices are on the rise, led by oil, which is up more than 40% over the past year. The Fed's preferred inflation barometer rose to an annual rate of 2% in March, reaching the level targeted by the central bank. Economists also have a wary eye on wage inflation, which has started to tick up as the labor market hits full employment. The most recent gauge showed wages rising at an annual rate of 2.7%, still well below the 4% level reached prior to past recessions.

It's little wonder that the Fed is hyper-alert to signs of an overheating economy, says David Kelly, global strategist at J.P. Morgan Asset Management. A massive stimulus injected into an aging expansion, he says, is "like a keg added to the frat party at 2 a.m., making the party louder but the hangover worse." Kelly notes that the Fed will be watering down the beer with monetary tightening. He also says that although a recession seems distant now, when the economy eventually slows, "the Fed will be asked to cut rates in a significant way. It can't do that unless rates are significant to start with."

Markets can take Fed rate hikes in stride as long as they are moderate and gradual, which is likely. Kiplinger thinks the Fed will hike rates a total of three times this year, bringing the federal funds rate, the Fed's benchmark rate, to 2.25%. Expect rates on 10-year Treasuries to reach 3.3% by year-end, up from about 2.5% at the start of 2018. Bond prices, which move in the opposite direction of interest rates, will remain under pressure. So far in 2018, the Bloomberg Barclays Capital U.S. Aggregate Bond index has lost 2.7%. (For more on this, see Our Mid-Year Bond Outlook.)
Peak Earnings

Corporate profits fuel stock-price gains, and some market watchers are worried that earnings are now as good as they'll get this economic cycle, giving the market little to anticipate. Wall Street analysts expect per-share earnings for companies in the S&P 500 index to surge 22% this year, compared with 12% growth in 2017 (see the chart on page 50). Growth next year is penciled in at just 9%--closer to the long-term average of 7%--as the windfall from corporate tax cuts dissipates.

But a peak in growth rates doesn't mean that profits won't continue to climb further into record territory. It just means they'll do so at a single-digit rate. "I don't want investors to get upset about peak earnings," says John Lynch, chief investment strategist at LPL Financial. "There's no reason to sell everything and climb into a bunker." He notes that, going back to 1950, the average time between peak earnings growth and the next recession was 49 months--more than four years. And over those periods the S&P 500 rose an average of 59%.

In the meantime, the strong expected earnings growth for 2018 coupled with the recent market correction means that stock valuations have come down to more-reasonable levels. The price-earnings ratio for the S&P 500 is down from about 18.6 at the market's peak in January to 16.6 recently. That's still above the five-year average of 16.1 and the 10-year average of 14.3. The question is whether P/Es will expand or contract from here, as investors decide how much they're willing to pay for each dollar of a company's earnings. Our year-end target for the market assumes that P/E multiples will stay about where they are now. But if analysts' forecasts for S&P 500 earnings of $176.60 a share in 2019 prove too rosy, P/Es would have to rise for the market to hit our target.

Although companies are upbeat about prospects for increasing profits and for economic growth overall, many have expressed concerns about potential headwinds--namely, the higher costs of rising wages and commodity prices, as well as escalating trade tensions. A more restrictive immigration policy could exacerbate labor shortages and contribute to higher wage growth, says Invesco's Hooper. On the trade front, the hope is that talks with China can avert an all-out tariff war. And so far, at least, protectionist rhetoric from the Trump administration seems "more bark than bite," says Mike Bailey, director of research at FBB Capital Partners.

Policy concerns will take center stage leading up to the midterm elections in November, and the months preceding the voting could be rocky. In midterm-election years going back to 1946, the S&P 500 has fallen an average of just over 1% in the six-month periods ending October 31, according to Sam Stovall, chief investment strategist at investment-research firm CFRA. With midterms that take place in the first term of a presidency, the drop is 3%, on average.

There's a case to be made for a more bearish outlook for 2018, and we'd be remiss not to acknowledge it. Because markets tend to react to developments six to nine months in advance, the good news on the economy and earnings might have been reflected in the strong market gains in the second half of 2017, says Doug Ramsey, chief investment officer at research and money-management firm Leuthold Group. "Profits have been terrific--enjoy them," he says. "But remember, the market paid you for them months ago. Don't submit another invoice." With the end of the Fed's monetary easing, it's possible that there's just not enough money sloshing around in the economy to push share prices higher, says Ramsey. He believes the S&P 500 could end the year at 2550, down about 6% from recent levels.
Where to Invest Now

We think there's plenty of opportunity left in the market, but the playbook at this stage of the game might surprise you. Normally, in a bull market this long-running, investors might amp up bond holdings in relation to stocks, or gravitate toward the more-defensive stock sectors, including companies that make consumer staples, telecom firms and utilities. That's probably not the right call now, though, as bonds and high-yielding "bond proxies" in the stock market sink as rates rise, and some consumer-staples firms also reel from changing consumer tastes and competitors' inroads.

For the money you do hold in bonds, consider maturities on the shorter side, which are less sensitive to interest rate swings. A strong economy allows for a little more risk when it comes to credit quality, favoring corporate debt over Treasuries. One good bet is Vanguard Short-Term Investment Grade (VFSTX), which yields 3.0% and is a member of the Kiplinger 25, the list of our favorite no-load funds. Take advantage of Fed rate hikes with a floating-rate bank loan fund, investing in short-term loans with rates that adjust upward with market rates. We like Fidelity Floating Rate High-Income (FFRHX), yielding 3.5%, or PowerShares Senior Loan Portfolio (BKLN), yielding 3.9%. The exchange-traded fund is a member of the Kiplinger ETF 20.

With stocks, start with so-called cyclicals--economy-sensitive industrial, tech and energy firms, as well as companies that make or provide nonessential consumer goods or services.

Industrial companies have the most to lose from trade tariffs but should benefit from increased spending on infrastructure, defense, and corporate work space and equipment. Fidelity MSCI Industrials Index (FIDU), a Kip ETF 20 member, counts two stocks worth exploring among its top holdings: Boeing (BA) and Honeywell International (HON).

Energy stocks haven't yet caught up with the strong gains in oil prices, but they pay attractive dividends in the meantime and are a classic inflation hedge. Refiners, including Marathon Petroleum Corp. (MPC) and Valero Energy (VLO), benefit from increased U.S. crude exports. Master limited partnerships, beaten down by tax uncertainties earlier this year, seem like bargains now. (For more energy picks, see Stocks to Energize Your Portfolio.)

The market has yet to sour on tech stocks, and you shouldn't, either. "Cloud computing, e-commerce, streaming media and online advertising are durable themes," says FBB Capital's Bailey. That augurs well for fan favorites such as Alphabet (GOOGL). Non-marquee names will thrive, too, as the tech sector receives a good share of corporate America's rising capital-spending budget. Bailey recommends semiconductor maker Microchip Technology (MCHP). Or consider ON Semiconductor (ON). The seasoned team at Fidelity Select Technology Portfolio (FSPTX) has beaten the fund's benchmark in eight of the past 10 calendar years.

Companies that cater to consumers with money to spend should continue to prosper as paychecks get bigger and rising home prices and 401(k) balances make households feel wealthier. Top holdings in the Consumer Discretionary Select Sector SPDR ETF (XLY) include Amazon.com (AMZN) and Walt Disney (DIS).

Financials have been solid performers and should continue to thrive in a strong economic and rising-rate environment. Financial Select Sector SPDR (XLF) is a broadly diversified Kip ETF 20 member that holds banks, insurers and asset managers in its portfolio. Its top bank holdings are concentrated in large money-center institutions. SunTrust Banks (STI) is a regional player with a focus on Florida, Georgia, Tennessee and Virginia.

Size-wise, small-company stocks have momentum, with the Russell 2000 index, a favorite small-cap barometer, up 6.4% so far this year and trading at new highs recently. Small firms are getting an outsize lift from corporate tax cuts, and because their revenues are mostly domestic, they are largely tariff-immune. Consider a couple of Kip 25 standouts: T. Rowe Price QM US Small-Cap Growth Equity (PRDSX) and T. Rowe Price Small-Cap Value (PRSVX).

Don't ignore the world beyond the U.S. At least 30% of your stock portfolio should be in international holdings, and a slice of your bond allocation, too. Read 7 Super Foreign Funds and 5 Great Foreign Stocks Selling at a Discount for our recommendations.

Finally, consider investing a [em]soupcon[/em] of your portfolio outside traditional stock or bond offerings. These alternative investments, which zig when stock markets zag, are good diversifiers and can be a valuable defense against stock market declines. Hedge inflation with DoubleLine Strategic Commodity Fund N (DLCMX) or invest in takeover targets with IQ Merger Arbitrage ETF (MNA), which has a low-volatility strategy.