The Risk to the Rally

Posted on Sunday, January 28th, 2018

The Risk to the Rally is the Rally itself. We came across a note from a research firm that we will not name. We highly respect the firm but the comment struck us like a thunderbolt. “Nothing can seemingly stop this market in 2018”. That is a very bold statement with 11 months to go in the year. A great start that has us running with the bulls but investors may be getting just a bit ahead of ourselves.

“With a 6.1 percent year to date gain and just three down days in the fifteen trading days of 2018, nothing can seemingly stop this market in 2018,” the firm’s analysts wrote Wednesday.

So far in 2018 we have rising bond yields, full employment, a Federal Reserve that is raising rates, trade friction, a falling US Dollar, tax reform and a runaway stock market. The punch line is that we might as well be talking about 1987. We wrote last year that the Trump Administration’s policies may give the FOMC the cover that they need to raise rates. The problem now is that Trump Administration policies could force the Fed to raise rates faster than they would like. A seemingly lower US Dollar policy, tax reform, trade wars and deregulation all could help foster that inflation the FOMC has been wishing for and force them to be more hawkish when it comes to monetary policy. At some point those rising yields will put pressure on risk assets.

“Obviously a weaker dollar is good for us as it relates to trade and opportunities,” Mnuchin told reporters in Davos. Mnuchin said recent declines in the value of the dollar against other currencies were “not a concern of ours at all.” – Steven Mnuchin US Treasury Secretary

From our good friends over at the Global Macro Monitor blog here is their thoughts on the latest developments out of Washington DC.

We have voiced our concern as we have noticed over the past few weeks the dollar weakening as interest rates are rising. A red flag.

Bad Timing 

The U.S. economy is humming at full capacity with inflation already on the cusp of moving higher. A weaker dollar is, effectively, a monetary easing and makes the Fed’s job that much harder at a time when financial conditions are incredibly loose.

The Administration also just announced the implementation of tariffs on solar panels and washing machines. LG Electronics has already announced they plan to raise prices on some of its models.  Retaliation by our trading partners seems likely.  Ergo inflationary pressures increase on the margin

The measured pace of the Federal Reserve is much like the measured pace of the Greenspan Fed in the mid 2000’s. The paradox then was that as the Fed kept raising rates at a measured pace the market kept roaring higher. Effectively, financial conditions got easier the more the Fed raised rates. That is the same paradox we have today. Financial conditions indicate easier conditions as the market heads higher with rising yields.

We feel that looser financial conditions are being exacerbated by the Fed’s frog in the pot. If the Fed continues to slowly boil the water asset prices will continue to trend higher, however, the downturn in markets, when it comes, will be worse. The Fed, at some point, should shock markets and raise rates 50 BP. Unfortunately, we do not feel that they will have the political will to hit markets with a 50 BP rate rise. That would certainly get markets attention. Otherwise, it may be up to inflation or possibly a trade war to get the market’s attention.

 Howard Marks is out with his latest memo this week and it is well worth the read. He has a new book coming out in October that we are looking forward to reading on cycles. Here are some of the highlights of what he had to say on his Latest Thinking this week. Go on to read the entire memo. It is worth the time.

The bottom line of the above is that some people are excited about the fundamentals, and others are wary of asset prices.  Both positions have merit, but as is often the case, the hard part is figuring out which one to weight more heavily.

 Closer to the bullish end of the spectrum or the bearish end?  Or balancing the two equally?  My answer today, as readers know, is that I would favor the defensive or cautious part of the spectrum.  In my view, the macro uncertainties, high valuations and risky investor behavior rule out aggressiveness and render defensiveness more sensible.

For one thing, I’m convinced the easy money has been made…., isn’t it appropriate to take less risk in equities than one took six years ago?

Prospective returns are well below normal for virtually every asset class.  Thus I don’t see a reason to be aggressive.

At times when the economy does well, risk doesn’t rear its head, risk-takers prosper and the returns on low-risk alternatives are unattractive, investors tend to drop their prudence and conclude that high prices aren’t a problem in and of themselves.  This usually turns out to be a mistake, but it can take years. – Howard Marks

Now it seems that everywhere there is talk of melt up. We pointed to that possibility over a year ago. We tend to be early. Being early is a good thing. It allows for us to prepare. It is time to prepare. We are preparing for higher interest rates, higher than expected  inflation so that leads us to consider adding commodities and further shortening our duration in bonds while also cutting back on risk overall. The January Barometer tells us that with January up 7.5% in 2018 that should lead to a positive year. Great start but no time to rest. Keep in mind there may be some bumps along the way.

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I  think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

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Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.