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2017 Stock Market Outlook

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I have done a market outlook every year in recent memory. However, the format is in need of a makeover.

I now realize that it is a waste of time explaining why the market is still bullish. That is because a bull market is the natural state of affairs which takes the vast majority of the time.

So instead our focus should be on what it would take for the bear to come out of hibernation. That will be followed by a section pointing out specific strategies that will tip the odds in your favor to beat the market this coming year. I hope you agree this is a much better format to get you on the path to investment success.


Bear Watch

Bear markets emerge for one of two reasons:

1) Recession looms on the horizon awakening the next bear
2) Valuations get stretched (Ex. The bear market that started in 2000)

There are no current whiffs of a recession in the air. In fact, most experts are looking for a step up in economic growth given the pro-growth initiatives proposed by the Trump administration (lower taxes and less business regulation).

Unfortunately history has many examples of the economy humming right along and then a recession jumps out of nowhere. So we will all need to keep a watchful eye on the key indicators with ISM Manufacturing, ISM Services and employment being the best early warning signals. Also, the possibility of nasty trade wars could be the initial spark leading to economic decline.

More . . .


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Now let's address the other side of the coin...valuation. I know folks who point to a historical average PE of 15 in order to say that this market is getting stretched given the current PE of 17.5. However, there is much more to the story.

You have to remember that PE's in the latter stages of bull markets typically move higher than average given the confidence folks have in a positive outcome. So a PE of 17-18 is more standard at this stage of the game.

Lastly, and most importantly, is the relationship stocks have with Treasury rates. In general, the earnings yield for stocks is just a little bit higher than the 10 year Treasury. So let's do that math.

Earnings yield is the inverse of PE. So dividing the $130 in expected earnings for the S&P by the current index price produces an earnings yield of 5.65%. Whereas the 10 year Treasury is only providing a meager 2.36% yield for investors. Given this historical relationship there is still ample upside for stock prices.

What if rates keep rising? Yes, this is another item to watch out for in 2017. However, 10 year rates would need to be above 3.5% for that to be of greater concern.


3 Ingredients to Outperform

Those who want to buy index funds and go to sleep will likely earn a cozy 5-10% on the year. For those willing to be a bit more selective they could come out 2-3X further ahead in focusing their money in the best stocks. Let me share with you the 3 key ingredients for a portfolio likely to outperform in 2017.

Ingredient #1: growth, Growth, GROWTH!

Defensive investments outperformed for all of 2015 and the first half of 2016. That boring investment party is now over. No longer should you focus on the safest of safe stocks. The way to outperformance is by finding companies that are experiencing exceptional growth.

On top of that seek companies where earnings estimates are on the rise...which as you know is the foundation of the Zacks Rank and its 26% average annual return. That's because these are the companies with the best growth prospects which is a beacon signaling other investors towards the shares. So focus on Zacks Rank #1 and #2 buy rated stocks.

Ingredient #2: Go Small or Go Home

This one goes hand in hand with Ingredient #1 above. The Flight to Safety movement the past two years also meant outperformance for large cap stocks and those with large dividend yields.

Now those ultra-conservative names are played out and growth oriented small caps and mid caps are starting to win the day. This trend should continue given all the ground they need to make up from the past couple years of underperformance.

Yes, these smaller stocks are generally riskier. That is why you should consider having more stocks in your portfolio, each with a smaller allocation. This form of diversification also helps mitigate risk so you can enjoy greater rewards.

Ingredient #3: Value

It never hurts to buy stocks at a discount to their peers. The problem is that most investors have a set of historical standards for what they believe equates to a value stock. I am referring to certain measures of PE or Book Value or PEG etc. that typically denote an undervalued security.

Unfortunately, nearly 8 years into a bull market you will discover that most every stock is above those levels. Thus, those looking for absolute value based on these historical measures will find no stocks in their basket. So the key is to use relative value measures to squeeze out additional gains. That is where the Zacks Value Score comes into play.

For example, our "A" rated value stocks are in the top 20% in terms of the value criteria that have been proven to lead to outperformance. Combine that with "B" rated stocks and you will be focused on the top 40% of value stocks available. These stocks should make up the bulk of your portfolio. And yes, do strongly consider selling those with D or F ratings for this important criteria as they will prove to be a drag on your portfolio.


What To Do Next

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Best regards,

Steve

Steve Reitmeister has been with Zacks since 1999 and currently serves as the Executive Vice President in charge of Zacks.com and all of its leading products for individual investors. He is also the Editor of his personal portfolio service, the Reitmeister Trading Alert.