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The Next Group of Winners

January 9, 2018, 10:15 am

It was very encouraging to see how the market traded last week – the S&P 500 soared through the 2,700-point limit while the Dow cracked 25,000 and the NASDAQ leapt above 7,000. Once again, tech stocks led the charge and the FANG group – Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Alphabet (GOOGL) – hit record highs.

We’re in an environment that’s very good for growth stocks in particular, although it wasn’t always that way. Remember, back in the beginning of 2017 it was all about the Trump Trade – companies set to benefit from the policies of the incoming administration. Deregulation and higher infrastructure spending would lead to better economic growth, which would help financial, industrial, energy and materials stocks.

However, things took a turn when the economy stumbled in the first quarter, and much of President Trump’s legislative agenda stalled. This led to a steep decline in interest rates, with the 10-year Treasury falling from 2.6% in March to 2.05% in early September. However, the economy was still sound, and this flashed a green light for growth stocks. Meanwhile, many of the Trump stocks struggled through the first 10 months of the year.

The value-oriented and Trump names had a much better fourth quarter as tax reform legislation, which seemed like a long shot at times, became a reality. Growth stocks continued to do well and realized a nice gain in the quarter, although their performance lagged the past two weeks when the 10-year U.S. Treasury yield shot up above 2.4% and reports of faltering iPhone X demand hurt the semiconductor companies that supply Apple (AAPL).

I don’t expect the iPhone issue to impact the broader growth market overall in 2018. However, higher interest rates are definitely worth keeping an eye on, especially with many valuations at lofty levels. The Federal Reserve is expected to raise the Fed Funds rate at least three times this year, and should also speed up the sale of the holdings in its portfolio. These moves will pressure both the short and long end of the yield curve. In addition, the European Central Bank (ECB) will begin to slow the pace of its quantitative easing (QE) program and potentially end it in October, taking away another pillar of support for bonds.

There’s little doubt that interest rates will move higher this year. While this could cause bouts of volatility, I still believe growth stocks will do just fine. I don’t expect the 10-year Treasury to get above 3%, so yields will remain supportive of stretched valuations. In addition, if there are any signs of a slowing economy or the markets looking shaky, the Fed will pull back on tightening to support the bond market and stocks.

Therefore, I look for many of our winners to emerge from the same groups as 2017: technology, healthcare and retail, but not so much the futuristic industries like the Internet of Things (IoT), robotics and artificial intelligence (AI). These have been talked up quite a bit in the financial media lately, but I don’t see any established “pure plays” here yet.

This could always change or one of these segments could become a large part of an established company. For example, tech giants AMZN, Microsoft (MSFT) and GOOGL all have AI software, but the size of these operations for now is swamped by other operations so they aren’t able to move the needle too much on sales and earnings. It is too soon to identify who will be the winners and losers in these exciting industries, so investing in them right now is too risky.

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