Before you read my investment outlook for 2018, you must first understand my financial situation and my biases. Our biases often warp our reality by anchoring us to past situations.
- Permanently left work in 2012 at the age of 34
- Net worth got crushed by ~35% in 2008-2009
- Small business owner who will benefit from the new tax plan
- New father with a spouse who is a full-time mom
- Favorite asset class is real estate with three physical properties in CA, one in HI
- Worked in equities for 13 years at a couple large investment banks
- Have significant investment positions in stocks, bonds, and real estate
With this background information, I believe 2018 will be the last year of good times where assets remain relatively stable as they track historical returns. Let’s discuss each asset class in a little more detail.
Stock Market Outlook: One Last Hurrah
According to the U.S. Small Business Administration, small businesses account for 48% of national employment. In number, they represent 99.7% of all businesses in the country. In other words, it is the guy with the plumbing store or the gal with the digital online marketing agency who make up the heart and muscles of the American economy.
Based on my interactions with other small business owners, everyone I’ve talked to is extremely excited about lower taxes and potentially less red tape. It’s really less regulation that most owners are looking forward to, and not so much the 20% deduction of qualified small business income.
As business owners, we hardly EVER feel the government is on our side because we’ve got to: 1) pay license fees, 2) pay special small business taxes, 3) pay both sides of the FICA tax, 4) pay an accountant to figure out our more complicated taxes, 5) wonder why we can’t collect unemployment after our business goes under, and much more.
With the passage of the new tax plan, there is finally hope the government is now on our side. Having a tailwind feels so much nicer than facing a headwind while climbing a hill – which is often what running a business feels like. As a result, I believe there will be a natural inclination to reinvest in our respective businesses and ultimately grow revenue. Higher revenue growth equals higher profits and higher company valuations.
Publicly traded companies are just a larger reflection of privately owned small businesses. And I think the mood in the boardroom is as bullish as ever with a 21% permanent corporate tax rate.
When there is business euphoria, as there is now, valuations matter less. The chart below is the S&P 500 Case Shiller P/E ratio as of January 2018. Instead of investors now thinking 33.27X is too high, perhaps investors are now thinking there’s another 10X multiple higher to go until we reach 2000 peak bubble levels.
Nobody really thinks we’re going to get to 44X, but it’s nice to know we still have this historical valuation buffer before everything blows up. After all, corporate cash balance sheets are massive compared to 2000, rates are accommodative, taxes are lower, and earnings are still growing.
Given we’re now in the final stages of a blow off where it’s liquidity, excitement, and FOMO driving the markets, I expect to see the S&P 500 touch 3,000 in 2018. If we get back to 2000 peak level valuations, we’re talking ~3,600 on the S&P 500, which isn’t going to happen. I expect downside risk of 10% for an even risk / reward ratio. I’m buying the dips.
Bond Outlook: Low Interest Rates
I’ve said this before, and I’ll say it again: we are in a permanently low interest rate environment. The 10-year bond yield has been going down since the late 1980s due to information efficiency, globalization, and policy efficacy. I expect interest rates to remain accommodative for the rest of our investing lives.
For 2018, I’m looking for another sub-3% level for the 10-year bond yield, and more likely an average of 2.6%, despite a couple more Fed Funds rate hikes expected this year. In other words, I expect bonds of all types to at least provide a total return equal to their coupon return as principal values hold rock steady.
With the Fed raising the short end, and longer term rates staying steady, the yield curve is flattening. Historically, a flat or inverted yield curve portents an imminent recession as higher rates on the short-end choke off credit growth, make existing credit more expensive and curb excess reserves, thereby slowing the economy.
But if the Fed is really going to cement itself as an inflation fighter, then this belief gives confidence for bond traders to invest in longer duration Treasuries at lower yields because no accelerated inflation is expected. Hence, I’m confident investing in 20-year municipal bonds that pay a 3.5% – 4% tax free yield for the low risk portion of my net worth.
We will know the end is near if the Fed raises the Fed funds by 1% and the long end remains flat. That’s when inversion occurs and should have enough time to reduce our risk exposure by then. I expect downside risk of half the coupon bond yield. I’m buying muni bonds whenever the 10-year bond yield goes above 2.6%.
Real Estate: A Tale Of Two Cities
Remember how I said in June 2017 that the rental market was soft in San Francisco due to a large supply of new condominiums and nose-bleed level rents that far outpaced wage growth? From 2H2015 to May 2017, I rented out my house for $8,800 – $9,000/month. When I tried to get prospective new tenants to pay the same rent in May 2017, I got zero takers, despite aggressively marketing the house for 45 days. The best two offers I got were for $7,500 from a divorcee with an unstable startup and from a family of six with a dog who wanted to move in in two months. So, instead of going through the pain of continuing to be a landlord, I sold the house for a little over 30X annual gross rent.
The numbers are finally showing up in the data. Check out the rent prices for one bedroom and two bedrooms in December 2017 according to Zumper. If there was a three bedroom segment, I’m sure the numbers would look even weaker. Like stocks, real estate prices should trade on earnings fundamentals. With a decline in rent in so many of the most expensive cities and new negative tax laws in effect, real estate prices should remain soft in the most expensive markets.
Take a look at NYC housing market data from Douglas Elliman. Sales volume and prices headed down in 4Q2017 as buyers took a wait-and-see approach regarding the tax plan. Now that the tax plan has passed, it is worse than most people expected due to the $10,000 SALT cap and the $750,000 mortgage cap for interest deduction.
Real estate investors should view NYC and SF as “leading indicators” of what should be expected for other expensive real estate markets. Now that prices are softening, you should be in no rush to buy. Be picky about what’s likely going to be the largest purchase of your life. Focus on location and expandability, the #1 way to increase your chances of making money in real estate. If you can build for $200/sqft and sell for $400/sqft, you win. And most of all, run the numbers to see if valuations make sense.
With the slowing of coastal city real estate, it’s only a matter of time before non-coastal real estate slows as well. But figuring out the timing of when the slowdown will occur and by how much is the biggest conundrum. Three to five years tends to be a good lag, so we can make an educated guess that between 2019 – 2021 is when the data will appear. Let’s just say 2H2020 to be more precise.
I don’t think there will be more than a 5% – 10% correction in coastal city or non-coastal city markets over the next couple of years because the economic engine is still quite strong. Further lending standards have tightened since the last financial crisis. Therefore, if you’re buying a home to live in for the long term, you should be fine.
Some folks have questioned the wisdom of my $810,000 investment in real estate crowdfunding outside of San Francisco. Understandable, given the absolute dollar amount sounds large. But I had a $2,740,000 position in a single SF property with a $815,000 mortgage where rents are declining. Therefore, I’ve reduced risk exposure while diversifying into 12 different non-SF properties where rents are stronger. Further, I keep my alternative investments to no more than 10% of my overall net worth and still have three California-based properties to manage. Always think in percentages
Enjoying One Last Year Of Good Times
As a business owner, I haven’t been this bullish since 2007, when I got promoted to Vice President at my banking job. Of course a year later, shit hit the fan and I saw a 35% destruction to my net worth in a matter of months. If a downturn happens again, I’m better prepared because I’ve got far more passive income streams, a variety of defensive investments, and a much lower debt to equity ratio.
If one can get a 10% return in stocks, a 4% return in bonds, and an un-levered 5% return in real estate without much volatility, I say that’s pretty easy money. If these return do come to fruition, perhaps I’ll finally be satisfied with a blended 2% – 3% guaranteed rate of return in retirement.
If you haven’t done so already, run your investment portfolio through an investment analyzer to see what your latest exposure is to the market. Then carefully analyze your net worth composition and make sure you are comfortable with its construction. I wasn’t entirely comfortable about my net worth composition in 2017, but now I am for 2018.
Update Nov 7, 2018: Volatility is back with Trump now talking about trade wars. Democrats take the House and the Republicans retain the Senate. The yield curve will be flat after two more rate hikes in 2019 as the long end still isn’t going up much, and coastal city real estate is slowing as expected. Real estate is also slowing as expected. Time to be more cautious all around. Build your cash hoard!