Happy New Year to everyone. Wall Street celebrated the first trading day of 2018 with a solid start. While many had feared that the first few days could see some profit taking focused on 2017s winners, the leaders yesterday were largely the same high profile names that have been market leaders throughout this entire business cycle. Also notable yesterday was a decline in both bond prices and the dollar.
The conventional wisdom, which is hard to disagree with at the moment, is that the U.S. economy, as well as those of most developed nations in the world, are experiencing some modest acceleration in growth. Lower corporate taxes in the United States for 2018 will accelerate earnings per share gains for American companies. Since earnings are probably the single biggest driver of stock prices, the conventional wisdom is that stock prices will rise again in 2018.
But we should remember that while earnings expectations can still rise as economies expand, hints of inflation and the probability that interest rates in the U.S. will rise this year (we can argue later by how much) suggest that the rate of increase in stock prices may not match the rate of improvement in earnings. Moreover, while we have not witnessed extreme euphoria similar to what we witnessed in the Internet bubble of the late 90s or the LBO boom prior to the 1987 crash, there are signs of euphoria. They are most present in the world of cryptocurrencies. At the moment, in dollar terms, the speculation surrounding bitcoin and its brethren is modest compared to the Internet or housing bubbles of past decades. But as it continues to grow, it serves as an obvious warning sign that at some point, some blow off correction will become both necessary and constructive.
For a year or more, investors have been waiting for the so-called 10% correction. Why 10%? Because it is large enough to be scary, but with the economic backdrop so strong, the external pressures don’t appear to be sufficient to ignite a true bear market where declines could be 20% or more. There is nothing magical about 10%, except that it is a round number and there is no obvious timing for such a downward move. Almost by definition a correction starts unexpectedly. It could be set off by:
- Surprising and unexpected central bank action.
- Changes in economic policy in China, perhaps to slow growth in order to rein in debt.
- A sudden move in currency or debt markets, perhaps correlated with an acceleration in inflation.
- A Trump tweet.
There are many more red herring risks I can name, but you get the point. The odds of escaping two years without so much as a 5% correction are small. But with that said, corrections are not long lasting and most quickly reverse if the economic backdrop remains small. Thus, while it is nice to have some cash to take advantage of a correction when and if it happens, it is probably foolhardy to sell trying to guess a correction is imminent. Unless you are fortunate enough to sell at the exact top and buy back in at the exact bottom, such an effort simply isn’t going to work. What is more likely is that markets will fall a quick 5% or so in a way that ignites selling pressure and the buyers won’t return until stocks are 5% or more above their bottom. Thus, the bottom line is to stay true to your asset allocation unless (1) you believe the end of the business cycle is near or (2) speculation is so extreme that risks start to outweigh rewards. Just to put an exclamation point on what I just said, if you want to buy bitcoin here, you have to ask the obvious question, weighing the chances that bitcoin is going to double from here versus the chance that it will retreat 50% or more. In my mind, your answer is going to be a complete guess. Ultimately, the bitcoin buyer presumes there is someone out there willing to pay more than present prices. The bitcoin seller opines that once the bubble bursts, whether it be a day or a year from now, there might not be any buyers at all. So far, we have seen very little of that foolishness in the stock market. But there is some. Tesla has a market cap almost equal to that of General Motors. Not only is GM bigger, it will probably sell more electric cars this year than Tesla. That won’t matter in 10 years if Tesla is a dominating car manufacturer. But what if Tesla is simply a niche player in the very high end of the automotive market like Ferrari, whose market cap is only about 30% that of Tesla.
As I have hinted in recent letters, I think the sky above us as we start the year is almost cloud free. One can argue that growth might even accelerate in the first half of the year as the benefits of tax cuts start to roll through the economy. Hopefully, the current frigid weather doesn’t hold down first quarter growth. If it is a passing two-week phase without serious snow-related disruptions, it probably won’t have a meaningful impact. But we have seen Q1 weather sidetrack economic recoveries before, so weather bears watching. With that said, as the year progresses, there is the likelihood that storm clouds might increase, probably not enough to end the bull market altogether, but enough to increase volatility and raise the risk of at least a moderate correction. Here are some things to watch:
- While deregulation and the impact of the tax cuts will continue to provide an economic tailwind, much of that good news is already baked into stock prices. Trump has a big economic agenda, one that will be delineated in the days and weeks ahead. However, from now on, everything has to get through Congress in a bipartisan fashion. Nothing significant, other than judicial appointments, can pass the Senate with less than 60 votes. Trump and Schumer, both tough New Yorkers, understand each other. But that doesn’t mean either wants to work with the other. As a for instance, Schumer wants DACA extended. Trump wants a wall built along the Mexican border. Schumer will support stronger enforcement of immigration laws, but isn’t likely to provide explicit funding for the wall. Is there a possible compromise here? That is the magical question. The same can be said for infrastructure. Both want it, but they are going to disagree on how to pay for it.
- There are hints that disruptions around the world could lead to higher oil prices than are currently forecasted. Venezuela faces a possible total meltdown. Oil is its only significant source of revenue, but the country is so broke that it lacks the resources to pay for products and services needed to extract it. In Iran, pressures are starting to build. The possible outcomes range from brutal suppression to regime change. Libya and Nigeria are constant sources of angst. If Iran, with its finite revenue sources, is forced to spend more in country and less stirring the pot everywhere from Syria to Yemen, then the whole Middle East dynamic could change. Meanwhile, in the U.S., while fracking is boosting production, oil exploration firms are being forced to focus more on cash flow and less on outright revenue growth. A confluence of these factors could result in oil prices for 2018 quite a bit higher than consensus forecasts. That would serve to put upward pressure on inflation and serve as a tax on consumers.
- The single biggest risk for 2018 is where long term interest rates will be at the end of the year. Most forecasts center on a rate for the 10-year Treasury below 3%. After years and years of low interest rates, few want to stick their necks out and predict anything higher. But if wages are growing at 3% or more by year end (they may already be growing at that rate according to some Federal Reserve data), and oil prices lead an uptick in commodity prices overall, there will be upward pressure on interest rates. The key then will be central bank reaction. In the U.S., the Fed has already stopped cutting rates and has begun to sell bonds into the market. Europe and Japan, however, remain sellers. Europe suggests that may change by year end. It is the low competitive rates overseas that hold back U.S. rates. The bond market is clearly global. But if rates overseas start to normalize as central banks pull back, a 10-year yield of 3% or even quite a bit higher is not a remote possibility. Should rates rise faster than expected that would certainly be a trigger for a correction.
But I don’t want to harp on the negatives, at least not yet. Until the 10-year gets over 2.6%, the trend remains our friend and clear skies are still with us. While there are some looking for major market rotation in equity markets in 2018, I for one don’t see it. Certainly, some of the most severely beaten-down groups like retail and energy can rebound at least early in the year. If oil prices surprise to the upside, energy may lead throughout the year. But the root causes of a stronger economy are going to be more money in consumer pockets, more rapid investment spending by corporations, and profound systemic changes caused by new technology from cloud computing to artificial intelligence, to the ongoing development of safer, and ultimately, autonomous vehicles. That suggests more of the same, not a major change in either our economy or stock leadership.
Today, Mel Gibson is 62. John Paul Jones of Led Zeppelin fame is 72.
James M. Meyer, CFA 610-260-2220
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