Key Points While many investors are focused on strong economic fundamentals, supply and demand dictate the market, not the economy. 2017 was a historical year, but it has likely sucked up the amount of money available to buy stocks. Current economic conditions mean that more wealth is not likely to enter the stock market. Structural demand is also weakening as the Federal Reserve is tightening monetary conditions.
A Rough Beginning to 2018
The recent volatility in markets has brought a lot of rhetoric from professional investors. Most are saying this volatility is healthy, and that strong fundamentals will prevail. However, while economic fundamentals still point to a healthy economy, the stock market still needs cash to increase stock prices. The forces of supply and demand dictate the market, not the economy.
In 2018, demand for US stocks will be low. High investor sentiment in 2017 likely pulled all of the money from the sidelines, as the market had a historical year. Future economic growth is not likely to bring more cash to the markets, and structural demand for stocks is weakening.
2017 - Awakening the Animal Spirits
When Donald Trump won the presidential election, investor sentiment rose fast. He had promised tax reform, healthcare reform, and infrastructure spending on the campaign trail. All three could bolster the economy and the markets. Also, the expectation that he would get things done shot equities higher.
The election also boosted consumer confidence by awakening the "animal spirits". People believed in the economy again, and consumer spending increased. This set investor expectations higher, and demand for stocks continued to rise.
As the year went on, economic data showed what all investors were hoping for: accelerating growth, low inflation, and rising consumer confidence followed by higher consumer spending. Plus, all investors kept the possibility of tax cuts in the back of their minds, and when it finally came, it spurred the markets even more.
With this perfect storm of economic data, everyone who was going to buy stocks, bought them. Expectations in 2017 were so great, and so high, that the market "melted-up" to produce an S&P 500 return of more than 20%, with historically low volatility. This occurred in the eighth year of the bull-run. People were buying stocks because of "the fear of missing out", meaning they were buying stocks because they did not want to miss out on the opportunity to grow their portfolio.
Economic Conditions Limit Stock Market Demand
In the beginning of an economic cycle, unemployment usually begins to decline, and that increases the amount of wealth within the system. As wealth grows, more money is saved, and some of that moves into the equity markets, thus raising prices.
Right now, we are at the later end of the economic cycle, and there will not be an influx of wealth to push stocks higher. The economy is fully employed, and has been for sometime. Market demand for stocks is going to remain low because people have already entered the market with their savings.
Tightening Monetary Policy
Since the Great Recession, the markets have had very accommodative monetary policy. At the time, the Federal Reserve's solution to help the economy was to boost investment spending. They did this by lowering interest rates to historically low levels.
Then, the Fed started to buy bonds in the open market. These purchases provided two tools. First, it kept interest rates low by creating artificial demand for bonds. Second, it added more money into the system, raising the money supply. Both of these actions were designed to raise the amount of investment in the economy, by making money easy and cheap.
Consequences of Easy Money
Since the bottom in 2009, the S&P 500 has risen by over 325%. The 10-year treasury fell to its lowest yield ever; in 2016, it reached a low of 1.367%. The unintended consequences of super easy monetary policy was that companies were buying back stock and raising dividends rather than focusing on research and development and other investments for their future. These buybacks continued to raise demand for stocks, and with bonds being so weak, stocks were a better alternative.
Now, as the US economy is growing stronger, the Fed is working to reverse their easy monetary policy and normalize it. This means interest rates are rising, and their bond purchases are stopping. Money supply is being taken out of the market, and financial conditions are tightening. The structural demand for stocks that was created after the financial crisis is now going away.
Conclusion
Demand for stocks is low. Tightening financial conditions mean that demand that was once there, is being taken out. Current economic conditions tell us that the growth in economic activity is not going to add a dramatic amount of wealth into the markets. Finally, extremely high investor sentiment in 2017 means that there isn’t much money left on the sidelines to be deployed. These three factors tell me that the stock market has likely reached a peak.
However, a lack of demand does not mean there is an abundance of supply. Since the fundamentals are so good, investors do not want to pull money out of the market. Also, the promise of repatriated funds going back to investors is likely a strong reason to hold stocks, for now.
The End of the Beta Trade?
From here, it is likely to become a stock picker's market. What we will see is that the indices like the S&P 500 will stay flat or range bound. Companies that continue to surprise and perform well will be rewarded with higher prices. While stocks with weak earnings and outlooks will be punished. Cash will be rotated out of the bad performers, and into the good ones until there is finally a recession. The Beta trade is likely over, for now.
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Submitted March 05, 2018 at 01:41PM by BR-Technicals http://ift.tt/2Fr8Cg0
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