What 5 Top Fund Managers Expect in 2018

This has been a strange year for the stock market. What was odd wasn't performance per se--the S&P 500 steadily climbed this year, rising by nearly 20% as of this writing--but rather the lack of volatility or concern in what, to many people, has felt like one of the more uncertain environments in a long while.

Threats of conflict with North Korea, a special counsel investigation, a war of words on social media between world leaders, and more could have caused investor panic. Yet the VIX index (which measures market volatility) hit all-time lows in 2017, while equity valuations climbed.

What will happen in 2018? Of course, that's anyone's guess at this point, but a few things are for certain. The post-recession bull market is entering its ninth year--it's the second longest bull market in history, only behind the booming 1990s--and valuations are higher than their historical norms.

Yet for many, equities remain the more attractive asset class, as fixed-income prices could fall as interest rates rise. Many managers think it's going to be harder to make money in the markets in 2018, but there are still opportunities.

Here's what five Morningstar Medalist managers expect in the year ahead.

Justin Tugman, comanager of Janus Henderson Small Cap Value JSIVX

"It's difficult to imagine that we'll see another year of strong equity market performance given what we had the last two years. If you look at 2017, it seems the market chose to ignore risks, but we think there are risks building out there. When you combine that with lofty valuations, we believe it makes sense to be defensively invested. Equities are still a better place to be relative to fixed income and other classes, but it also makes sense to be cautious.

"We think valuations look very stretched. That doesn't mean they can't go higher than where they are today, but our view lends more to downside risk than upside potential. At some point the market is going to care about geopolitical issues or dysfunction in Washington. It has a way of suddenly sneaking up on us and issues that were ignored start to come up.

"As for opportunities, there's not one sector that stands out, but certain segments of the market, like banks, where multiples are a little cheaper, and consumer staples, where valuations have come down, look decent to us. Small-caps are also not as expensive relative to large-caps. Small-caps will also benefit more from tax reform, as they pay higher rates."

Pete Santoro, comanager of Columbia Select Large Cap Equity NSEPX

"We're still optimistic for 2018. GDP is growing globally and domestically, and we think companies have found religion on things like productivity--they're focusing on return on investing capital, more buybacks, and dividends. We'll also still see earnings growth next year. Valuations have crept up, but they aren't so high that the market can't do well.

"We think the world is undergoing some dramatic transcendent secular changes, and that's opening up a lot of opportunities. Changes like how everyone's shifting their retail buying online and that traditional retailers have trouble catching up--these changes are real and massive. There are new winners and losers. What people are missing about technology is the duration of growth. People get caught up in the immediate multiple. We look at cash flow projections for up to five years in tech stocks, and they have a long way to go. That, and financials, are two sectors we're optimistic on.

"There are geopolitical risks, such as North Korea, terrorism, instability overseas. And there are domestic risks, too, like what comes out of Washington and inflation; that's something we're concerned about. Volatility should pick up, but that creates opportunities for stock pickers like us. When balance sheets go on sale, that could be a good thing."

Richard Lane, comanager of Broadview Opportunity BVAOX

"Next year marks year nine of an economic upturn, and if you look at all the economic data, then you'll see we're approaching close to full employment, we're at peak auto sales, and most of the cyclical indicators you'd look at point to a mature economy. Equity prices are above average--I'd say they're rich by several standards--so as we go into 2018, it's going to be harder to find bargains.

"We're trying to buy good businesses at bargain prices and that's getting more challenging. Still, it's harder to find a better environment for consumers. There's cheap financing for autos,

"The tax bill is going to add another inning or two to an already extended cycle. It will stimulate capital spending--and capital spending and housing are two areas that have not been robust this cycle. One nuance to 2017 has been the focus on growth stocks, while value stocks have lagged. We believe the rubber band has stretched to the point where the market will rotate in the opposite direction next year. So, we have accumulated a modest overweight in energy. We also believe our housing-related holdings have some upside left."

Paul Magnuson, comanager of AllianzGI NFJ Mid-Cap Value PQNCX

"We're close to one of the longest economic expansions, but what's unique about this one is that the growth rate is lower than every other previous expansion. Since we're so long in the cycle it would seem reasonable that we would have a pullback--and it could be from a sudden shock to the system. Corporate profits have increased, but they're still off their March 2007 peak. Lower interest rates and an expansion of central bank policies have also made it difficult to value stocks, as there's an absence of a reliable discount rate.

"All of this tells us that it's time to get defensive. The market is vulnerable and there are pockets of excess valuation. We see a lot of speculation in the market and we see it in high valuations. So how do we position our portfolio? We want to have higher quality names where earnings are visible. We want to emphasize dividend yield, because dividend paying stocks tend to hold up better on downside and they're less volatile. We don't want to go for lower quality even though we see lower valuations there, because these are traps for us and we avoid them in this stage of the market."

Larry Puglia, manager of T. Rowe Price Blue Chip Growth TRBCX

"We could see a similar progression to what we've seen in 2017, but with lower gains. Stocks have performed so well, so there's not the same type of upside for many stocks.

"There also aren't as many attractive names, and even for the names that are attractive, the upside is not as great as it was. That's a mathematical fact, and something we need to acknowledge. But one of the good things about investing in the types of companies we're trying to seek out is that these companies are compounding earnings at a brisk rate, generally 15% on average. So that means, with the passage of a time, even if a company is reasonably valued, it can soon become more attractive.

"We're overweight in technology, healthcare, and consumer discretionary. Some of these companies have performed well, but they've also experienced a pullback recently, so these companies do look promising over the next 18 months. I like tech and healthcare because they're heterogeneous, in that you can create varied exposures within a popular industry. In tech, we look for companies that have recurring revenue, like

"Risks include regulatory. Even with the tax change, we're not sure what the repercussions will be. It may not be favorable to growth, as some have suspected. The biggest risk is valuation. Stocks are not overvalued across the board, but the market is moderately more expensive than the 25-year average for most metrics. But there have been pullbacks by as much as 10% as of late in some stocks, so there are selected stocks that we think can perform well."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.