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It’s August, the dog days of summer, but stocks just keep chugging higher.
On Wednesday the Dow Jones Industrial Average DJIA, +0.24% hit a new all-time closing high above 22,000, while the S&P 500 index SPX, +0.05% and the Nasdaq Composite index COMP, +0.00% closed near record peaks. The CBOE Volatility Index VIX, +1.65% the so-called “fear” index, at one point last week tumbled to a record intraday low below 9. It’s a bit higher but remains in a low range not seen in two decades.
Low interest rates (despite the Federal Reserve’s goal of gradually raising rates and shrinking its balance sheet), strong corporate earnings, decent GDP and jobs growth with no real inflation, and the lingering hope for tax reform in Washington, D.C. have kept stocks moving higher.
And except for potential geopolitical crises like North Korea, I don’t see anything on the horizon, especially a recession, that would keep stocks from advancing over the next year or so.
Nonetheless, it’s been more than 270 days since the last 5% pullback, one of the longest such stretches since 1950, according to Strategas Research. At this point, a 5%-10% correction would be healthy. Here are three reasons I think one is likely in the months ahead.
1. The Transports are diverging from the Industrials. The Dow Jones Transportation Average DJT, +0.32% is down almost 6% from its mid-July all-time high through Wednesday. That’s no catastrophe, but it’s a striking divergence from the records being clocked by the other major averages. It’s also a warning flag, since Dow Theory holds that the Transports must confirm the Dow Industrials’ move to all-time highs for the bull to continue.
The Transports comprise airlines, railroads, and package delivery services like FedEx FDX, +1.35% and UPS UPS, +0.99% They’re a good barometer for both consumer spending and companies’ equipment purchases, so their weakness could foreshadow an economic soft patch ahead. However, the Transports lagged the Dow early this year, in 2016, and in 2012, and the bull market is still here. It’s not a perfect indicator, but it does bear watching.
2. Earnings aren’t giving stocks the pop they used to. So far, the second-quarter earnings season has been very good. As of last Friday, 73% of the companies in the S&P 500 that have reported earnings beat Wall Street’s earnings and revenue estimates, according to FactSet. Blended earnings growth is a solid 9.1%.
But no good deed goes unpunished: “For the first time in 17 years,” Business Insider wrote, “there are no short-term rewards for topping earnings forecasts.” (That doesn’t seem to apply to companies like Apple AAPL, +4.73% , whose unexpectedly strong revenue and earnings growth caused the stock to pop early Wednesday.)
Bank of America Merrill Lynch found share prices on average fell five days after companies reported positive earnings or revenue surprises. That suggests good earnings already are in many stocks’ prices and have lost some of their power to move markets higher.
3. Washington faces big gridlock. Anyone who thought that Republican control of the White House and both houses of Congress would end Washington gridlock and make the federal government function smoothly must have been smoking something. After the health-care fiasco, how can anyone expect this fractured Congress to do anything big?
That could mean trouble in the fall, when Congress will have a long list of must-do items and little time to do them.
Treasury Secretary Steven Mnuchin, like his predecessor Jack Lew, warns the debt ceiling will have to be raised by Sept. 29 or the government won’t be able to pay its bills. Also, like his predecessor, Mnuchin has called for a “clean” debt ceiling increase, which many Republicans adamantly opposed under President Obama.
Congress must also set a new budget by Oct. 1 or face a government shutdown. Approving a new budget is also a prerequisite to passing tax reform later.
Neither is a slam dunk, as Republicans and Democrats in Congress may hold out for their own pet projects. That’s why there’s likely to be suspense and volatility in the markets until lawmakers ultimately get a deal done, which I think will happen at the last minute.
Only then can Congress tackle tax reform, itself a political minefield because powerful interests want to protect their special tax benefits more than they want to lower rates for everybody. (Exhibit A: the mortgage-interest deduction.)
So investors shouldn’t count on tax reform until 2018, and even then it’s likely to be more of a tax cut than sweeping reform of the tax code. The much-touted “pro-growth” fiscal policies the election was supposed to usher in won’t help the economy much for quite a while. This is a disappointment just waiting to happen.
That’s why I’m looking for a potential 5%-10% correction in late summer or early fall. It won’t be the end of the world or the end of the bull, but it could be a real blow to a market where complacency reigns supreme.
Howard R. Gold is a MarketWatch columnist and founder and editor of GoldenEgg Investing, which offers exclusive market commentary and simple, low-cost, low-risk retirement investing plans. Follow him on Twitter @howardrgold.