Key Points

• Equity prices have advanced while sector leadership has changed dramatically as prospects for tax reform have improved.
• Stock prices may be growing more vulnerable to a near-term correction, but fundamental factors suggest no end in sight to the current bull market.

Investor attention remained focused on politics last week, with the North Korean missile test and Michael Flynn’s guilty plea drawing headlines. But tax reform was the biggest story, as investor optimism rose over increased prospects for a final bill. The S&P 500 Index rose 1.6% last week,¹ but even more notable was the sharp change in market leadership. Growth and momentum styles have outperformed for most of the year. But last week investors poured money into value sectors and those areas that may be poised to benefit from tax policy changes. In particular, banks, brick-and-mortar retailers, capital goods, media companies, transportation providers and homebuilders were up sharply while technology stocks lagged.¹

Weekly Top Themes

1. Tax reform made significant progress last week, but much still needs to be done. With the Senate passing its bill on Saturday morning, we now head to a House and Senate reconciliation process. We expect that will take at least several weeks, but the GOP is eager to offer President Trump a final bill before the winner of the Alabama Senate race is seated, which could be as early as December 26.

2. A strong start to the holiday shopping season shows consumer spending remains solid. Compared to last year, Thanksgiving weekend purchases were up 17% for online retailers and were flat for brick-and-mortar stores.² Both results were slightly better than expected.²

3. Manufacturing levels have softened but remain positive. The November ISM Manufacturing Index fell from 58.7 to 58.2, while the Markit purchasing managers’ index dropped from 54.6 to 53.9.³ Any reading above 50 indicates expansion.³

4. We expect corporate earnings growth to remain relatively strong. Earnings growth may have peaked, but we expect results to remain robust for at least the next year, which should provide a tailwind for equities.

5. Recent strong equity market performance could set the stage for a nearterm consolidation. The S&P 500 Index has jumped nearly 100 points over the past two weeks and close to 200 points over the past two months,¹ largely in anticipation of tax reform. We think the economic and earnings backdrop remains supportive for stocks, but markets may be getting a bit frothy.

Risks for Equities Remain on the Horizon

Equities have enjoyed hugely impressive gains so far this year, as fundamentals have improved and investor sentiment turned more positive. In our view, markets may be more vulnerable to a correction now than at the beginning of the year. At the same time, we find it hard to identify a specific trigger that could cause a more significant setback.

Normally, bull markets end as a result of rising inflation, slowing growth or a monetary policy mistake. None of those events seems likely any time soon. At some point, we think that government bond yields will likely rise more sharply than they have this year, and we expect global central banks to become less accommodative. Both events would likely contribute to stock market volatility and could represent headwinds. But neither event seems imminent. Central bankers are moving very cautiously and government bond yields have remained stubbornly low.

At the same time, we expect inflation to eventually move higher (especially wage inflation), but this should not occur dramatically or quickly. And finally, global economic growth appears to be improving, and we find it tough to make a case for a U.S. or global recession.

Over the next year, we think risks to government bond markets are likely to climb and equity market gains should be more muted than in 2017. But the fundamental backdrop suggests that a pro-growth investment stance continues to make sense, and we believe investors should continue overweighting equities in their portfolios.

Bob Doll is chief equity strategist at Nuveen Asset Management.

1 Source: Morningstar Direct, as of 12/1/17
2 Source: ISI Evercore
3 Source: Institute for Supply Management & Markit