Stocks in 2018 continue to be bright in the short term as their frantic climb higher continues this year. The S&P 500 is already up 5.6% so far this year. That’s on top of the phenomenal 19.4% rise last year.
This trend will likely continue for a while longer as there are a number of positive forces fueling stocks higher. First and foremost, the US economy continues to power higher.
Growth came in at a reasonably healthy 2.6% in the fourth quarter. Furthermore, preliminary estimates from the Federal Reserve estimate growth will come in at around a robust 4.2% in the first quarter.
This is truly exceptional economic performance. Moreover, it is backed up by a wide array of economic data that shows virtually every sector of the economy is picking up steam.
On top of that, President Trump and the Republican Party passed a tax cut bill that will likely boost growth further in the short term. This tax cut is particularly beneficial to large businesses because it cuts their taxes from 35% down to 21%.
A growing economy coupled with corporate tax cuts is great news for large corporations. This means the shares of large companies listed on S&P 500 have ample room to run higher.
But there is a storm brewing longer term.
Stocks in 2018 will get hit as interest rates rise
The Federal Reserve (Fed) has announced plans for three more interest rate hikes in 2018. Assuming the minimum quarter point raise, three more rate hikes would add up to a 0.75% rise by the end of next year.
That may not sound like very much. But actually, it’s a very big deal.
That’s because it will move real interest rates (nominal rates minus inflation) from negative to positive for the first time since the 2008 global financial crisis. This is a monster sea change.
A new generation of consumers and investors has emerged that has never had to worry about the cost of capital.
Thousands of businesses and millions of consumers are going to have to make a huge adjustment, and not all of them will get it right. This is just one way jerking the rug out from under a market addicted to cheap money can cause an earthquake.
Retiring the vast mountain of money printed since 2008
The Fed has been goosing the market with trillions of dollars in freshly-printed money for the better part of a decade. This has pumped up bubbles in the stock market, real estate and just about every other asset class under the sun.
Indeed, the S&P 500 price-to-earnings ratio stands at a nose-bleed 26.4-times earnings. The only time in history it’s been higher is before the Dotcom bubble of 2001.
But this bubble will deflate later this year as the Fed finally ramps up pulling easy money out of the markets. Last year, the Fed announced the sale of $10 billion of the mountain of Treasuries and mortgage-backed securities it bought with freshly printed money.
Doing this effectively removes this money from the US financial system. These liquidations will continue, gradually increasing to US$50 billion per month by the end of next year. Or, US$600 billion on an annual basis.
These plans illustrate a central conceit common to central bankers all over the world. They think they can dial market bubbles up and down at will, like a thermostat.
This is not going to be the case this time. Asset prices (including the stock market) are unsustainably over-valued. Even the smallest pin-prick from rising interest rates or tightening of monetary policy will be enough to trigger a correction.
A stock market collapse is not out of the question either if an untimely crisis hits markets as sentiment starts turning. Accordingly, savvy investors need to start pulling in their horns now as the stocks in 2018 gets worse as the year goes on.