The bulls are running wild. Stocks are higher, investor sentiment is higher, and there’s a feeling in the air as holiday seasonality approaches.
Excessive investor optimism poses some contrarian headwinds near term. However, a stronger economy bodes well over the longer term.
Economy and Interest Rates
As widely expected, the Fed raised interest rates last week boosting the fed funds target range by 25 basis points to 1.25% – 1.50%. It was the third increase this year and the fifth time since 2015 that the Fed has hiked short-term interest rates.
The move was interpreted as a bullish sign by the stock market, and broader financial markets. Federal Reserve Chair Janet Yellen reiterated what the economic data has been shouting the past several months.
The economy is gaining strength and gathering a measure of momentum. The fact that the equity markets continue to climb in the face of rising interest rates argues the fed funds level would have to go higher before impacting the economy and the financial markets. The Fed suggested that three more rate increases next year were likely but this would depend on the labor markets remaining strong and the prospects for inflation. Although most of the economic data continues to surprise to the upside, inflation remains conspicuously absent. The Consumer Price Index (CPI) for November showed core inflation at just 0.1% with virtually no change year-over-year. Passage of the new tax legislation, however, is a wild card in the equation next year. Lower taxes are expected to spur growth but at the risk of triggering inflation and a more aggressive monetary policy.
Market Fundamentals
The performance by the equity markets in recent weeks has shadowed the potential passage of tax legislation before year end. The largest risk to the stock market is that earnings growth decelerates in 2018 leaving an overvalued market vulnerable. But with passage of tax legislation nearly assured this threat is significantly diminished. It is estimated that a cut in corporate taxes from 35% to 20% could enhance S&P 500 earnings by as much as 10%. This is important given that without the benefit of tax reform, earnings acceleration is very difficult this deep into an economic recovery. Although it is difficult to predict what multiple the market will provide a one-time tax event, this is more than offset by the potential for the improved prospects for capital spending. Entering the new week the focus will be on a favorable outcome for tax legislation and the lure of Dow 25,000.
Stock Market Technicals
The S&P 500 Index, Dow Industrials and NASDAQ finished at new record highs last week. The weight of the technical indicators offers little evidence that the primary trend of the stock market is in significant jeopardy. The broad market continues to support further gains.
The NYSE advance/decline line has made new highs along with the averages. Within the S&P 500 Index, 81% of the industry groups are in uptrends versus 50% in August. Seasonal factors offer a tailwind for stocks deep into the first quarter with stocks higher more than 72% of the time in the final two weeks of the year. Investor psychology is the largest concern as the widespread complacency seen for most of 2017 has shifted to outright optimism. Consumer confidence regarding the economy has reached levels not seen in 17 years. Consumers are also bullish on the stock market. The University of Michigan’s survey of consumer optimism toward equities is higher than the 2007 peak. Other signs of excessive optimism are found in the record margin debt, historically high valuations and mutual fund and ETFs cash levels are at record low levels. Although it is unusual that stocks encounter weakness at the end of the year, the first week of January is often greeted by sellers who have waited to take profits late in the calendar year. Support is seen at 2575 to 2625 using the S&P 500.
Twitter: @WillieDelwiche
Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.
