Ever since the stock market started advancing again eight years ago, investors have been trying to predict what might bring it down.
There have been no shortage of candidates, from political uncertainty and pockets of economic weakness to elevated stock prices.
The list of potential dangers is limitless, but I would argue the following three factors loom largest in terms of potential impact. They aren’t all negative, but they are significant — and clearly on investors’ minds.
Federal Reserve policy
The central bank’s Quantitative Easing programs, designed to kick-start the economy during the recession and keep the recovery moving, have coincided with a sharply higher stock market and rising prices for other assets.
But the QE programs — focused around the Fed buying bonds with fabricated money to inject funds into the banking system — weren’t designed as permanent policies. That has prompted investors, economists and others to speculate on the eventual impact as the programs are reversed or unwound.
“Investors would be well-served to keep in mind that QE was far and away the biggest factor that drove asset inflation for the last eight years,” wrote David Karp of PagnatoKarp, a financial-advisory firm in Reston, Va. “A reversal of QE is one such event that will likely be disruptive to the artificial tranquility so enjoyed in the recent past.”
Stock prices have roughly tripled since QE1 was launched in November 2008, during the recession, followed by QE2 in August 2010 and QE3 in September 2012. With the Dow Jones Industrial Average and other yardsticks still near record highs, investors don’t appear overly concerned. The feeling seems to be that the Fed won’t do anything drastic enough to knock the market or economy off course. That seems a reasonable assumption.
There has been a lot of talk lately on how stock prices have gotten ahead of company fundamentals. There’s truth to that, yet operating profits for large corporations in the Standard & Poor’s 500 index have been rising lately, with analysts expecting further improvement ahead.
Many market watchers view price-earnings ratios and other valuation measures as high, though the degree depends on the measure used and the way it’s interpreted. For example, the S&P 500 stocks are trading around 17.5 forward earnings (those expected for the next 12 months), according to JP Morgan Asset Management.
That’s up but not excessively — the average of the past 25 years has been 16 times earnings.
Besides, low interest rates and other factors render traditional valuation measures less insightful than they were in the past, argued BlackRock, the giant investment manager, in a midyear update. “This could mean equities are cheaper than they look.”
Lofty stock prices reflect optimism over President Trump’s tax proposals, including the plan to cut individual taxes and lower corporate rates enough that companies would repatriate billions of dollars held overseas in foreign units. If Trump and congressional Republicans can’t deliver on those promises, expect a backlash. But companies on balance are faring well, with large corporations still flush with cash.
There are pockets of weakness and other reasons for concern — signs of a tight job market are one — but the economy overall is in decent shape. That’s good for investors, as prolonged stock-market declines rarely materialize unless a recession is near.
Interest rates remain low and inflation under control, with household net worth rising and consumer confidence on an upswing. Also, the economies of other nations are starting to shift into higher gear, including in Europe. And while the U.S. economy has been expanding for eight years now, that doesn’t mean the current cycle must end soon.
“The slower the pace of a recovery, the longer it takes to absorb economic slack — and the longer it takes to reach full capacity and ultimately the peak that signals the cycle’s end,” noted BlackRock in its report. “We believe the economy’s sluggish growth means that the current cycle has a long way to run.”
The economy would be more of a concern if the leading economic indicators were starting to sputter. But these 10 forward-looking variables still point to expansion ahead. The latest reading suggests the economy remains on track for 2% annual growth through at least the rest of 2017, according to the Conference Board, the research group that tracks the leading indicators.
With the stock market, anything could happen. A shock or other major negative development could send prices reeling. That’s why it always makes sense to cushion your equity holdings with bonds or cash. You just never know.
Most Americans have gotten this message by now. Many people aren’t even in the market or have much lower equity holdings than they should. It’s easy to get spooked by all sorts of financial, political or other dangers — perceived or real. The risks are limitless and memories of the severe 2007-2009 slide still fresh.
Yet the economy and corporate profits both have momentum now, and those remain the two key factors on which to focus, in my view. Unless current trends reverse, I don’t plan to bet against the market anytime soon.
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