Sometimes I’ll receive a question along the lines of “Hey, what do you think the stock market is going to do this year?” I’m assuming they’re looking for a very specific answer like “the stock market is going to rise 10% this year…” but markets and investing are not that clear cut. Even when you think you know or have very high conviction in an outcome, some unexpected exogenous event always seems to come out of nowhere that ruins your thesis and proves you wrong. This means that I assess markets using a probabilistic framework and position accordingly. For example, if I think “A” has a 75% probability of occurring, maybe I’ll only take 75% of the targeted position size. Or maybe I’ll hedge 25% of exposure.
So here’s my view of the broad US stock market for the remainder of the year. Please note – these are not predictions and this is not specific investment advice. This thinking is an ongoing process of evaluating and re-evaluating investment theses as information changes so I can be prepared to adjust portfolios if it looks like one scenario is starting to play out over others.
- 15% to 20% probability that we’re in the midst of a final blow-off topping process that would mark a major high
- 20% to 25% probability that we see some weakness this spring/summer (your standard pullback) but rally to see new highs before the end of the year
- 60% probability that we’re at the highs for the year
Scenario 1 – blow-off top
I wrote back in December about the topping process that the stock market often exhibits. Since then, we have not seen a pullback but have accelerated to the upside. This is a little concerning… The current environment has been and is becoming ever more similar to the late 1920’s: Europe was a disaster and money continued to pour into the US which caused US stock market go on an enormous move higher… until tariffs and a global trade war tipped the economy into a global depression (sound familiar?). If the relentless move higher in stocks continues like we’re seeing, we could quickly see a 20% to 30% move higher in the next 6 to 9 months. While that might sound exciting, history suggests a move of that magnitude would be the top of a bubble. Here’s an updated chart of the Dow Jones Industrial Average showing the accelerating pace to the upside:
Scenario 2 – pullback but sustained rally
Experiencing regular pullbacks in a market is normal and healthy. The lack of a pullback since the election back in November is not healthy and increases the odds of Scenario 1. If we finally see a decent pullback in the very near future, a sustainable rally could continue.
Scenario 3 – highs for the year (my current base-case)
In all likelihood, I think we’re at the highs for the year. Here are some warning signs I’m seeing that make me cautious about overweighting or investing new money in US stocks right here:
- Insider selling has been very high all year (executives are cashing out)
2. You tend to see the same pattern play out near tops and bottoms – the institutional “smart money” is cashing out at the top while retail investors/traders are getting sucked in because CNBC makes it seem so exciting and they just can’t miss out! And the reverse at the bottom where retail investors are panicking and bailing out while institutional investors are buying. Below is the latest chart from Bank of America Merrill Lynch detailing fund flows. In short, hedge funds and institutional managers have been net sellers into this rally while retail investors have been massive net buyers (chasing the rally).
3. Just about every investor sentiment survey is showing extreme bullishness – usually what you see around high points before a pullback
4. Economic data are likely to weaken this year and the effects of any positive changes from the Trump administration likely won’t hit until 2018. Consumer spending is a large part of the US economy and the consumer appears tapped out (being squeezed from rising costs without wage gains). Growth in consumer credit card debt continues to significantly outpace the retail discretionary spending numbers we’re seeing which implies people have been using credit cards more often just to cover essentials. Also, delinquency rates have been on the rise – a major warning sign.
Credit Cards and Other Revolving Loans – year-over-year growth
Credit Card Delinquency Rates – year-over-year change
So what is an investor to do? For starters, diversification is the simplest and smartest thing you can do. This means rebalancing your portfolio to lock in some gains in US stocks and increase exposure to just about everything else: international stocks, emerging markets, bonds, commodities, etc. Studies show that investors all over the world always have a home country bias, meaning too much exposure to stocks of their home country. Just take a quick look at your own portfolio to see what percentage is invested in US assets vs international. If it’s heavy US, it’s starting to look like a good time to diversify globally. I’ve become much more constructive on international markets over the past few months, from both a valuation and currency perspective. Bond yields have moved higher since the election so they’re a more attractive place to park some cash while you wait for better opportunities. Lastly, most commodities have been so beaten down the past few years that it has created some decent opportunities in commodity related stocks as well as direct exposure to commodities themselves.
It will be interesting to see how this year plays out with so much uncertainty around the path of fiscal policy (still no specifics yet). I don’t know where stocks are headed but I do know that moving forward the broad US averages are looking unattractive relative to other asset classes. Try to ignore the Siren’s call; diversification is always a good idea.
Thanks for following!
-Nick