Sharemarket investors have fared pretty well over the last couple of years. Taking its lead from the bull market on Wall Street, the Australian sharemarket is on track for a double digit return in 2017 following 11.8% in 2016. Admittedly, these returns include dividends and the increase in price terms is roughly half, but from an investor’s perspective, it is the total return that counts.

So, what’s the outlook for 2018 and how should you play it?

I start from the premise that Australia will follow the USA, and that a 10% return in both markets next year is a realistic expectation. While the USA is further advanced on the pessimism/skepticism/optimism/euphoria continuum, with inflation staying low, interest rates low by historical standards and economic growth in the major economies now in sync, company earnings can continue to grow and the share market can go higher. The risks to this scenario are the “black swan” event we can’t foresee, President Trump doing something crazy or impeachment proceedings commencing, or the US Federal Reserve tightening monetary policy more quickly than anticipated.

The outlook for the Australian economy is arguably a little stronger, as business confidence and business investment have picked up. This will need to flow through to consumer sentiment, but with employment conditions staying strong, no pressure on interest rates and (possibly) a slightly more stable political situation in Canberra, an improvement can be expected.

Critical to the local market (and economic growth) will be a competitive Aussie dollar. While there is a risk it could break down if interest rates in the USA rise too quickly (and the US dollar rallies), strengthening commodity prices could push it higher. Around 70 US cents seems to level that most agree is about the mark.

Can the Australian share market outperform the US market?

It has lagged the US market over the last few years as weakly represented domestic sectors, such as technology and consumer discretionary, have surged in the USA. I can’t see this changing in the short term, and barring a major hike in commodity prices (which would benefit the Australian share market), my sense is that underperformance is a more likely scenario. We might keep pace, but not much more than that.

So, how do should you play the Australian sharemarket in 2018?

Large caps or small caps?

One of the big themes in 2017 has been the underperformance of the major cap stocks. As the table below shows, the top 20 stocks, which make up about 45% of the total market capitalization, have returned 5.2% in 2017 – 4.6% below the broader market’s 9.8% (as measured by the S&P/ASX 200). Underperformance of 4.6% in 2017 follows underperformance of 3.0% in 2016.

Two things have caused this. Firstly, many of the top 20 stocks are “growthless”. That is, EPS (earnings per share) growth is close to zero or low single digit percent.

In this category, you can include the four major banks, Suncorp, Woolworths, Wesfarmers, Telstra and energy producer Woodside. Secondly, in their search for growth, fund managers have been reweighting towards midcap and smaller cap stocks. The Midcap 50 Index, which represents stocks ranked 51st to 100 in market capitalization, has returned 18.9% this year following a stellar 17.8% in 2016.

Small caps, as tracked by the Small Ordinaries Index (stocks ranked 101st to 300th by market capitalization) have rocketed back to form in 2017 with a return of 16.3%.

While the recovery of the resources sectors has helped (the small caps are overweight these sectors), small caps from other sectors are also generally higher.

Does this trend continue in 2018, or will there be a rotation back into the large caps?

My sense is that we are due for a little bit of rotation. Despite the Royal Commission, the outlook for the major banks is healthier (see below) and the major resource companies (BHP and Rio) should continue to be well bid. Further, some of the mid cap stocks have become very, very expensive.

I am not sure that the rotation will be that material (so that the performance is likely to be more even), so I would maintain some exposure to mid and small cap stocks. For the small, caps, a portfolio weighting of around 10% would be considered “neutral”.

Which sectors?

The table below lists the 11 industry sectors for the Australian sharemarket according to the GICS classification methodology. It shows the sector weighting as a proportion of the S&P/ASX 200, the return (including dividends) for 2017 and the return for calendar 2016.

Two matters stand out. Firstly, the variability of the returns, ranging from -25.4% to +27.0% in 2017, and secondly, the lack of consistency from year to year. The best performing sector in 2016 is only middle of the pack in 2017, while the best performing sector in 2017 was one of the weakest sectors in 2016. So, getting the view right on each sector, in terms of whether you should be overweight, underweight or neutral (index-weight), can have a pretty big impact on portfolio performance.

What will be the best performing and worst performing sectors in 2018? Here is my take on each sector (in descending order of market capitalization).

a) Financials – overweight
The major banks have been laggards over the last couple of years. With the capital outlook now secure, stable interest margins, no pressure on bad debts, and focus on cost control, mid single digit EPS growth is on the cards. Downside risks include the Royal Commission and the lack of volume growth. I think the market will get “bored” with the former, and the attraction of the high, secure dividend payments will provide sold support.

I am less excited by the insurers, or diversified financials such as Challenger or IOOF. The latter have had a pretty good run and are getting a touch expensive.

b) Materials – index-weight
I think you could make a case for being overweight material stocks such as BHP or Rio on the expectation that synchronized economic growth in the USA, Europe, China and Asia will keep demand for raw materials including iron ore and copper reasonably strong. Investment in new infrastructure will also help. The unknown is what happens on the supply side.

With the challenges in forecasting commodity prices, I am sticking at index-weight.

c) Real Estate – underweight
Capitalisation rates are low, many trusts are trading at a significant premium to NTA, distributions are unfranked, and if interest rates do head a lot higher, this sector will be exposed.

d) Consumer Staples – underweight
Despite Woolworths getting its act together, I expect that the major retailers will be challenged to grow earnings, as the supermarket wars show no signs of abating. Wesfarmers also has its hands full with its UK acquisition of Homebase. Stars of the sector in 2017 (A2 Milk, Bellamy’s, Blackmores and Treasury Wine Estates) look fully priced. This is a defensive sector, moderately underweight.

e) Health Care – index-weight
This is the best performing sector on the ASX over the last 10yrs, 5yrs, 3yrs and 1yr, and not a sector to be short as the tailwinds keep blowing. But it has had a fantastic run and some of the stocks are super expensive, not just compared to the local market but to global healthcare peers. Back to index-weight.

f) Industrials – index-weight
This sector is arguably misnamed, because some of the leaders (such as Transurban and Sydney Airport) aren’t really industrials in the classic sense. A stronger local economy and weaker Aussie dollar should theoretically help the sector. Because of the variety of companies that the sector covers, it is largely a stock by stock proposition.

g) Energy – overweight
With the oil price sitting comfortably above USD50 per barrel and OPEC appearing to have got its act together, I am inclined to play this sector on an overweight basis. We have seen corporate activity with Santos and Woodside, and while the sector has performed strongly since Feb 2016, my hunch is that there is more action to come. A risky call, but overweight.

h) Consumer discretionary – index-weight
An improving local economy should be good for this sector, but with the Amazon scare lingering over the retailers and weak wages growth moderating consumer demand, outperformance might not be on the cards. Like Industrials, very much a stock by stock proposition.

i) Telecommunications – index-weight
Following two years of very poor performance, value investors might see this as a sector to be overweight in. This looks like a “courageous” call, as displacement by the NBN and competition in the mobiles market is likely to restrict earnings growth.

j) Utilities – underweight
While sector weighting is small and won’t materially impact performance, government intervention will cap wholesale energy prices, restricting the growth of leaders such as AGL. Also vulnerable to higher interest rates.

k) Information Technology – index-weight
Sector weighting is so small that positions won’t materially impact performance.

Summary

This is how I think you play 2018:

• A slight bias for the large cap stocks; and

Sectors:

• Financials –  overweight
• Materials – index-weight
• Real Estate –  underweight
• Consumer Staples –  underweight
• Heath Care – index-weight
• Industrials – index-weight
• Energy – overweight
• Consumer Discretionary – index-weight
• Telecommunications – index-weight
• Utilities – underweight
• Information Technology – index-weight

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.