2018 Investment Outlook for Stocks Bonds and Real Estate

As we step into the financial landscape of 2018, it's crucial to examine our investment strategies, taking into account both the overarching economic environment and personal financial circumstances. Past experiences can shape our perspectives on investments, making it essential to identify biases that may cloud our judgment.

Understanding my own financial background provides context for my outlook. Having transitioned from a corporate job to entrepreneurship, I have witnessed the ups and downs of the market firsthand. Here are some key points that outline my journey:

• Left the corporate world in 2012 at age 34.
• Experienced a significant drop in net worth, approximately 35%, during the 2008-2009 financial crisis.
• Own a small business that stands to benefit from recent tax reforms.
• A proud new father with a spouse dedicated to raising our child full-time.
• Invested primarily in real estate, owning multiple properties in California and Hawaii.
• Spent over a decade in equities at major investment banks, gaining valuable insights into market mechanics.
• Holds substantial investments across stocks, bonds, and real estate.

Given this background, I predict that 2018 will mark a final phase of favorable conditions where asset values may maintain stability in alignment with historical performance. Let’s delve deeper into various asset classes and investment opportunities for the year.

Stock market outlook for 2018: a potential peak

The U.S. economy heavily relies on small businesses, which constitute nearly 99.7% of all businesses and account for about 48% of national employment, according to the U.S. Small Business Administration. This vital sector comprises local enterprises, from the family-owned plumbing service to innovative tech startups.

Conversations with fellow small business owners reveal a palpable sense of optimism surrounding tax reforms and reduced regulatory burdens. Business owners are primarily eager for less red tape, rather than just the 20% deduction available for qualified small business income.

The challenges of running a small business often leave owners feeling overwhelmed by government regulations, which can include:

• Paying various licensing fees.
• Covering unique small business taxes.
• Shouldering both employer and employee contributions to FICA taxes.
• Hiring accountants to navigate complex tax obligations.
• Facing the reality of not being eligible for unemployment benefits if the business fails.

With the introduction of the new tax legislation, there’s a renewed sense of hope among entrepreneurs that the government may finally be more supportive of their endeavors. This change in sentiment can lead to increased reinvestment in businesses, driving revenue growth, which in turn boosts profits and enhances company valuations.

Publicly traded companies reflect the sentiment of these smaller enterprises. With a permanent corporate tax rate of 21%, many corporate leaders are brimming with confidence. During times of economic exuberance, as we are currently observing, the importance of valuations tends to diminish. The S&P 500 Case Shiller P/E ratio stood at 33.27 in January 2018, prompting some investors to speculate on the potential for further growth.

While reaching the peak valuations of the year 2000, which saw P/E ratios soar to 44, appears unrealistic, the current environment does offer a buffer of historical valuation metrics. Companies today boast robust cash reserves compared to two decades ago, interest rates are favorable, and earnings continue to rise.

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As we approach what appears to be the final phase of market exuberance, characterized by liquidity and fear of missing out (FOMO), I anticipate the S&P 500 could reach 3,000 in 2018. Should we experience a surge back to year 2000 valuation levels, the S&P 500 might touch 3,600, although this scenario is highly unlikely. Consequently, I foresee a downside risk of around 10%, which presents a balanced risk-reward scenario. My strategy is to capitalize on any market dips.

For more information on asset allocation, see the proper asset allocation of stocks and bonds by age.

Bond market outlook for 2018: enduring low interest rates

It's essential to reiterate that we currently inhabit a landscape characterized by persistently low interest rates. The 10-year bond yield has been on a downward trajectory since the late 1980s, influenced by factors such as information efficiency, globalization, and effective policy measures. I predict that interest rates will continue to remain accommodative for the foreseeable future.

For 2018, I foresee the 10-year bond yield averaging below 3%, likely around 2.6%, even with anticipated hikes in the Fed Funds rate. This suggests that investors can expect bonds to yield returns at least equal to their coupon rates, as their principal values are expected to hold steady.

The Federal Reserve's strategy of raising short-term rates while long-term rates stabilize contributes to a flattening yield curve. Historically, such conditions can indicate an impending recession, as higher short-term rates can stifle credit growth, making borrowing more expensive and slowing economic activity.

However, if the Fed is genuinely committed to combating inflation, this confidence may encourage bond traders to invest in longer-duration Treasuries at lower yields, as inflation remains subdued. For instance, I am currently favoring 20-year municipal bonds, which yield a tax-free return of 3.5% to 4%, representing the low-risk segment of my investment portfolio.

We should monitor for signs of an economic shift, particularly if the Fed raises the funds rate by 1% while long-term rates remain stagnant, which could signal an inversion of the yield curve. If such a scenario occurs, we will have ample time to adjust our risk exposure. My strategy involves purchasing municipal bonds whenever the 10-year yield exceeds 2.6%.

Real estate market insights: contrasting scenarios

Reflecting on my previous commentary from June 2017, I noted a softening rental market in San Francisco, driven by an influx of new condominiums and rental prices that had escalated well beyond wage growth. For instance, I rented out my property for $8,800 – $9,000 per month from the latter half of 2015 until May 2017, only to find that prospective tenants were unwilling to pay the same rate when I sought new renters.

The latest data corroborates this trend, revealing declines in rental prices for one- and two-bedroom apartments in December 2017, as reported by Zumper. Just like equities, real estate prices should be evaluated through the lens of earnings fundamentals. An ongoing decline in rents across many high-cost cities, coupled with unfavorable tax reforms, suggests that property values will likely remain subdued in these markets.

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New York City’s housing market offers further evidence of this trend. According to Douglas Elliman, sales volumes and prices dipped in the fourth quarter of 2017 as buyers adopted a cautious wait-and-see approach in light of new tax legislation. The repercussions of the tax plan, particularly the $10,000 SALT cap and the $750,000 limit on mortgage interest deductions, have proven to be more detrimental than anticipated.

For a deeper understanding of tax implications, refer to the maximum mortgage tax deduction benefit.

Investors should regard the markets in NYC and SF as leading indicators for other expensive real estate markets across the country. With prices softening, exercising caution before making new purchases is wise. Focus on key factors such as location and potential for expansion, which is critical for maximizing returns in real estate. A scenario where you can build at $200 per square foot and sell at $400 per square foot is a winning strategy. Always conduct thorough analysis to ensure valuations hold up.

As coastal markets begin to cool, it’s likely that real estate in non-coastal areas will follow suit. However, predicting the timing and extent of this slowdown poses a challenge. Typically, there’s a lag of about three to five years, suggesting we might see these trends materialize between 2019 and 2021, with a more precise estimate pointing to the second half of 2020.

I do not anticipate a correction exceeding 5% to 10% in either coastal or non-coastal markets over the next few years due to the underlying strength of the economy and tighter lending standards implemented since the last financial crisis. Therefore, for those considering purchasing a home for long-term residency, prospects appear favorable.

Some may question my decision to invest $810,000 in real estate crowdfunding outside of San Francisco. While the figure may seem substantial, it’s important to note that I previously held a $2,740,000 stake in a single property in San Francisco, with an $815,000 mortgage in a declining rental market. By diversifying into twelve different properties outside of San Francisco, I have mitigated risk while investing in areas with stronger rental prospects. I consistently aim to limit alternative investments to 10% of my overall net worth, while still retaining three properties in California for management.

Anticipating another year of economic optimism

As a business owner, I feel a level of optimism not felt since 2007, coinciding with my promotion to Vice President in the banking sector. The subsequent financial crisis saw a rapid decline of 35% in my net worth; however, I am now better prepared for potential downturns. My portfolio features a more diverse array of passive income streams and defensive investments, coupled with a significantly lower debt-to-equity ratio.

If one can achieve a 10% return in stocks, a 4% return in bonds, and an unleveraged 5% return in real estate with minimal volatility, it may seem like straightforward gains. Should these returns materialize, I would consider myself fortunate to secure a blended guaranteed return of 2% to 3% as I approach retirement.

For those who haven’t evaluated their portfolios recently, I recommend utilizing an investment analyzer to assess your market exposure. Analyze your net worth composition to ensure it aligns with your financial goals. I wasn't entirely comfortable with my net worth composition in 2017, but I now feel reassured as we move into 2018.

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Update Nov 7, 2018: Volatility has returned as discussions around trade wars intensify. Democrats have taken control of the House while Republicans maintain the Senate. The yield curve is expected to flatten following two additional rate hikes in 2019, as long-term rates show little movement, and coastal real estate is slowing as anticipated. It’s prudent to adopt a more cautious approach across the board and build your cash reserves!

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