The stock market won't be automatic money next year, but will reward investors who can move money, stomach more volatility -- and bet more heavily on European and Japanese stocks than on American companies, strategists at Bank of America Merrill Lynch (BAC - Get Report) say.
The S&P 500 stock index will only hit 2,300 by the end of 2017 -- about 2% better than now, chief investment strategist Michael Hartnett said at the firm's investment-outlook conference this week. But that seeming placidity masks shifts below the surface.
Value stocks will outperform growth. Financial shares will replace consumer stocks as market leaders, a move that has been ongoing since Donald Trump won the presidency on Nov. 8. Protectionism beneficiaries are better positioned than companies that depend on globalization, like United Technologies (UTX - Get Report) or Boeing (BA - Get Report) -- both have had scrapes with the president-elect.
Materials stocks and commodities trump -- pun intended -- technology shares and bonds. Infrastraucture stocks like Fluor (FLR - Get Report) that have risen on expectations of public-works spending are already fully priced or overvalued, Merrill says. And the firm insists that active management -- which is, after all, what Merrill sells -- should beat macro-oriented or index investing.
Finally Merrill says stocks in both Europe and Japan will beat U.S. equities in 2017, even though U.S. stocks have climbed 4.9% in the month since the election. Japan's Nikkei Index is up 15% over that period. The Bloomberg European 500 is up a little more than 5%. Both Europe and Japan benefit more from a pickup in inflation than the U.S. will, Hartnett said.
"The U.S. has been the big deflation winner," he said. Japan, Europe, small-cap stocks and value stocks are "all ties to something that has changed, which is the direction of inflation.''
Some of the calls underlying Merrill's base case for 2,300 are worth a closer look. Within broad calls like "financials are good" or "energy stocks should rebound," good judgment is a must.
The call to buy financial stocks like JPMorgan Chase (JPM - Get Report) and Goldman Sachs (GS - Get Report) could be shaky for a few reasons. For one, buyers of global commercial and investment banks are counting not only on a climb in interest rates, but also on a paring back of the Dodd-Frank law that Republicans blame for holding down bank lending and profits.
"Senate Republicans have generally been reluctant to give specifics about what changes to Dodd-Frank they will propose and ... investors will not get significant details until early 2017," Keefe Bruyette & Woods' Washington analyst Brian Gardner said. "We remind investors that Senate Democrats will have enough votes to filibuster a Dodd-Frank corrections bill they oppose and we expect Democrats will block any legislation they think dismantles the core parts of the law. "
Dodd-Frank may be enough to make investors look harder at regional banks like PNC Financial (PNC - Get Report) . A Trump portfolio that LPL Financial planners are pitching emphasizes regional banks, which stand to see wider interest-rate spreads, but aren't counting on major Dodd-Frank changes. Asset managers like T. Rowe Price (TROW - Get Report) and BlackRock (BLK - Get Report) also can ride a healthier economy without counting on Washington to boost business. They're up more than the market since the election; T. Rowe is up 23%.
Finally, the bull case on both banks and energy depends on how far recent upward moves in interest rates and oil prices will go -- and they may not go far. Merrill sees 10-year Treasury rates hitting just 2.65% next year -- up from 2.39% now, as the Federal Reserve raises rates only once in 2017.
Oil is actually down this week, as the market absorbs the news that the Organization of Petroleum Exporting Countries, or OPEC, has agreed to limit oil production. It's not a certainty that the deal will hold -- non-OPEC member Russia hasn't yet agreed to honor it, and U.S. shale producers like Anadarko Petroleum (APC - Get Report) or Devon Energy DVN can begin drilling more at higher prices.
All of this argues for selectivity -- and a willingness to look outside the U.S.
Merrill is high on Japan because it believes Prime Minister Shinzo Abe and the Bank of Japan have finally managed to stimulate the nation's economy enough to break out of its long stagnation, said Chief Global Economist Ethan Harris. European stocks should benefit from a combination of economic improvement and a central bank that is actively stimulating Europe's economy even as the Federal Reserve begins to raise U.S. interest rates, Harris said.
Merrill is actually more bullish about 2018, at least as far as the U.S. economy is concerned, U.S. economist Michelle Meyer said. Much of the first half of 2017 will be devoted to seeing which of Trump's many policy ideas he is serious about -- like much of Wall Street, Merrill expects the new president to cut taxes but stop short of raising tariffs on Chinese or Mexican goods.