The stock market last week advanced 3 percent, heading towards my target of 2400. The Dow Jones Industrial Average broke above 19,700 and is within striking distance of the "psychological" summit of 20,000.
With just 250 points to go, it is extremely likely traders will try and push stocks to that level by Christmas. Woo hoo!
Before you go printing up your "Dow 20,000" hats, there is a dark side to the advance.
If you go outside and throw a ball into the air, it will travel until the momentum of the ball is overtaken by gravity. There is, just for a very brief moment, a point where the ball is stationary. However, eventually, gravity wins.
The same is true for market prices. As I discussed on Friday:
"The importance of understanding the nature of reversions is critical for investors. Markets rarely move in one direction for very long, notwithstanding overall trends, without a correction process along the way. It applies to individual sectors of the market as well."
" When there is a simultaneous culmination of overbought conditions combined with a more extreme deviation, corrections usually occur back to the underlying trend.
While the “Trump Rally” has pushed asset prices higher and triggered a corresponding 'buy signal,' that signal has been triggered at very high levels combined with a very overbought condition. Historically, rallies following such a combination have not been extremely fruitful."
While the "exuberance" of the Trump rally has certainly awakened the "animal spirits," the sustainability of the advance from such egregiously overbought conditions is questionable. David Rosenberg weighed in on this point via The Globe & Mail:
"Okay, so the president-elect is now at 3 percent, again skewed by two or three sectors. Big deal. Ronald Reagan, who was the original 'Make America Great Again' advocate (as opposed to a copycat), saw the equity market soar 6 percent in his first month in office.
Guess what? The market peaked less than four weeks into his term and for the next two years we had an economic downturn and a 25-percent slide in the stock market. The combination of rising bond yields, Fed tightening and a stronger dollar took care of that honeymoon.
After all, we all know what happens when the honeymoon is over. The hard work begins.
That slump we just saw in October export volumes and widening in the trade deficit is surely just an early sign of what is to come.
Before The Donald does anything on his first hundred days, something tells me the lagged impact of the tightening in financial conditions associated with the recent bounce in interest rates and appreciation of the U.S. dollar is going to come back and bite the economy in the tush, as was the case heading into 2016."
It's Beginning To Look A Lot Like…1999!
It is interesting to watch the excitement build around the market once again as we head into the New Year. There is an optimism rising the "new bull market" has finally arrived and we are set to start an unprecedented advance as the calendar turns.
You get the idea. And, as I showed last weekend, investor confidence is extremely high levels as well. But here is the latest from NAAIM which shows managers at a net 101% exposure.
See, it's all good….for now.
If this market rally seems eerily familiar, it's because it is. If fact, the backdrop of the rally reminds me much of what was happening in 1999.
The Fed was hiking rates as worries about inflationary pressures were present.
Earnings were rising through the use of "new metrics," share buybacks and an M&A spree. (Who can forget the market greats of Enron, Worldcom and Global Crossing?)
The stock market was beginning to go parabolic as exuberance exploded in a "can't lose market."
If you were around then, you will remember.
While inflation rates and GDP growth are substantially weaker now than in 1998, the recent turn higher is similar to what we saw during that previous period. In 2000, there was a spike higher in GDP which got the bulls all excited just before the recession took hold.
The same is true for interest rates which rose about 1.5 percent between 1998 and 2000. Rates then resumed their long-term downtrend in conjunction with the onset of a recession.
Of course, as rates, inflation, and economic growth were rising by small amounts, investors pushed assets prices higher expecting the longest economic growth cycle on record to continue for another decade.
Compared with that period, it’s possible to make the argument that we have 8-10 quarters ahead of us before a problem occurs. However, because GSP is running at half of the previous rate, there is substantially less room to fall before a recession sets in. In other words, in 1998, the economy had to decline from a 7.5 percent growth rate to hit recessionary levels.
Considering we are at 2 percent today, the time to recession will be considerably shorter, like two to four quarters kind of short.
The mantra of higher inflation and higher rates is good for stocks has once again returned as stocks enter their "melt-up" phase of the advance. It wasn't the case then and it likely won't be the case now.
While there is much hope that the new President and his newly minted cabinet will "Make America Great Again," there can be a huge difference between expectations and reality. And, like in 1999, there is just the simple realization that eventually excesses will mean revert.
Last One Out, Turn Off the Lights
The market is currently pushing well into 3-standard deviations above the 50-day moving average. Such extensions are rare and do not historically last very long.
With valuations high and the markets extremely overbought, corrections have been common.
Despite the rampant optimism running through "Main Street" and "Wall Street" since the election there is little changed economically speaking. The economy remains weak, labor costs have surged, monetary policy has tightened and a stronger dollar negatively affects corporate earnings. Wages haven't increased much for the average worker and employment is still trending lower.
In fact looking at the primary indicators of things that affect the production side of the economic equation, things don't look so good.
However, the markets rally on expectations. Therefore, here is the question you must answer:
"After a 200% increase from the financial crisis lows, trillions of dollars injected into the financial markets and the economy, and 8-years of economic growth, exactly what is not already priced into the financial markets?"
Valuations are also a problem (both P/E and Tobin Q-ratios) with investors currently on the wrong side of the equation.
For those long energy-related equities, this is likely a good time to take in profits and rebalance exposure during short-term corrections.
However, the bigger picture is that while long-exposure remains recommended currently, it is also critically important not become overly complacent. Just because the lights are still on and the music "still a pumpin'," smarter investors tend to quietly exit before the cops show up.
Just don't forget to turn off the lights if you are the last to leave.
Lance Roberts is a chief portfolio strategist and economist for Clarity Financial.
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