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Funds

12 Funds for 2018 and Beyond

Long-term picks for today's market.

This article was originally published in the January 2018 issue of Morningstar FundInvestor. Slight adjustments were made to reflect recent market changes. Download a complimentary copy of FundInvestor here.

The markets enjoyed a great rally in 2017, and then we gave some of that back in recent weeks. I don't know if this is a dip you should buy into or the first leg down in a serious sell-off.

But a quick recap of 2017 is in order. Emerging markets were the best place to be. The average India fund gained 47%, the average China fund was up 42%, and diversified emerging markets were up 34%. Foreign developed markets did almost as well, with gains between 22% and 32% for foreign categories.

And the United States was no slouch, with gains of 21% for large blend and 28% for large growth. The farther you move toward small value, though, the more mundane the gains are. Small blend was up 12% and small value 9%. That's the biggest gap between large growth and small value since 2007.

Bond markets were solid if less exciting. The average taxable intermediate-bond fund gained 3.7%, and the average intermediate muni-bond fund gained 4.6%.

Interestingly, some of the leaders continued to lead by losing less in the sell-off. Foreign funds recouped some losses because the dollar fell sharply, and large growth continued to pummel small value.

The two takeaways from the 2017 rally are: 1) You can't afford to be out of the market. It is tempting to market-time, but rallies are unpredictable, so stick with your plan no matter what the headlines say. 2) There are no screaming bargains left out there. Low interest rates and economic growth have pushed investors around the world to keep buying stocks, bonds, and any other financial asset. And no, a 10% sell-off doesn't really change that.

The New Tax Law As we start 2018, we also have a dramatic change in taxes in the U.S. It should prove a boon for corporations, and it is also expected to add a trillion to the deficit. You should talk with your tax preparer to see what impact it will have on you, but so far, as investors sift through all the changes, it does seem like there are some clear takeaways.

First, analysts expect much of the benefit in lower tax rates to flow through to shareholders in the form of dividends and stock buybacks. Thus, we have a new support to the equity market just as it seemed to be getting too pricey.

Second, we have a boatload of stimulus coming at a time when the economy is already strong. When we got stimulus amid the recession of 2008-09, it didn't spur inflation. But we might not be that lucky this time with the economy going full throttle.

The New Fed Jerome Powell replaced Janet Yellen as Federal Reserve board chair, but that's not all. Stanley Fischer and Daniel Tarullo have resigned from the board of governors. In addition, there were two openings when President Donald Trump took office. Thus, you have four pending vacancies. Trump has nominated Marvin Goodfriend to take one of those seats, but Goodfriend hasn't been approved yet.

It is very rare to see so much change in such a short period of time at the Fed. And markets hate uncertainty at the Fed. The current Fed had signaled it planned to hike interest rates three times in 2018, but does that plan really matter with a line change in the works?

It is not clear whether this change is bullish or bearish for equities or for bonds. It would seem to increase the chances that volatility picks up at the very least.

Let's take a look at my ideas for where to invest.

Small Value

Small value last lagged large growth by a wide margin in 2007 and before that in 1999. In the ensuing years, small value outperformed dramatically the first time but only modestly the second time. This certainly reminds me of 1999 when small-value stocks just looked stodgy and boring in comparison with the dynamic Internet and technology companies powering the markets.

Dividend Strategies This trend seemed rather overdone (and it might still be), but then the tax bill gave another shot in the arm to dividend-payers and stock-repurchasers alike. Not to mention that low bond yields make it pretty appealing to draw some income from equities.

Inflation Plays Productivity gains and sluggish growth outside the U.S. in recent years have kept inflation under wraps. But as I mentioned, the huge stimulus and deficit increase could mean that inflation could return. If you have a bond-heavy portfolio that is vulnerable to rising inflation rates, it makes sense to have some protection. However, I wouldn't make inflation protection a huge part of my portfolio. Also, these are not very tax-efficient, so they are best held in a tax-sheltered account like a 401(k) or IRA.

Let's Get Cautious It seems to me that caution is in order, so here are four particularly cautious funds.

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