Thursday, January 19, 2017

Greed And Six Other Risks Could Tank Your Investments In 2017

Risk No. 1 might be your own stubborn bullishness.


By Michael Brush
MarketWatch
January 19, 2017

While many investors question the Donald Trump stock market rally, it could be for real. The main reason: If Trump’s pro-business vibe takes hold, it could unleash powerful “animal spirits” among business leaders and investors.

That could add significant growth, since there is plenty of room for soaring animal spirits to boost the economy.

To quantify animal spirits, Wells Capital Management strategist Jim Paulsen suggests this measure: Capital spending by companies plus consumer spending on big-ticket items.

This gauge, which he calls “confidence spending,” is at just under 24% of gross domestic product (GDP). That’s about 15% below the average since 1950. In other words, there’s a lot of pent-up demand in the economy that “animal spirits” could unleash. That spending merely has to get back to trend to really boost growth — and the stock market.

But 2017 is not without risks. There are plenty of big ones out there. So while the market could see further gains, it is vulnerable to some nasty downward swings that you should be on guard for.

Here are seven potential risks that could spark a 10% to 20% bull market correction in 2017, and when they might play out.

Risk No. 1: You


If you’re like most people, you’re quite happy with your stock gains since the election, and hungry for ways to tweak your portfolio to get even more. How do I know this? Because sentiment measures from Investors Intelligence and the American Association of Individual Investors tell me so.

Your confidence makes you one of the biggest risks to the market right now. It’s one of the main reason I’ve been telling subscribers to my the stock newsletter, Brush Up on Stocks, to raise cash, bring down margin and exit dubious trades. (I don’t recommend getting out of medium-term positions because I don’t believe a recession is at hand.)

Sentiment measures are never a precise market-timing tool. But they can tell us when the market is vulnerable to pullbacks — like now. The contrarian logic here is that when investors are boldly confident, they’re complacent. That makes them vulnerable to surprises that could spook the daylights out of them, especially when the paper losses start applying psychological pressure.

“Exposure to stocks looks like a crowded trade,” says Bruce Bittles, chief investment strategist at Baird.

Individual investors are not alone in their exuberance. Cash levels at mutual funds have plummeted, and recent surveys by National Association of Active Investment Managers show 90% exposure to stocks, which is elevated. Bittles considers anything above 80% exposure to be a negative for stocks, in the contrarian sense. Excessive bullishness among the pros should not make you feel any better. They are just as susceptible to herd mentality as individual investors.

The timing: Sentiment can stay elevated for a while before a correction takes away the giddiness. But deteriorating market internals suggest this may now happen sooner rather than later. Market momentum is fading, points out Bittles. By this he means that participation is narrowing. As the Nasdaq NQH7, -0.09% and the S&P 500 Index SPX, +0.18% recently hit new highs, for example, more stocks were down than up. At both the Nasdaq and the New York Stock Exchange, the new-high list has remained relatively narrow.

Risk No. 2: You And Trump


Much of the renewed bullishness among investors and business leaders is based on high hopes that the Trump agenda will get through. These hopes pushed the National Federation of Independent Business Index of small-business optimism to its highest level in over a decade last month.

Betting on Trump is rational because he has solid Republican majorities in Congress, right?

Well, maybe not. Nothing is ever easy in Washington, especially when special interests stand to lose. Plus, a lot of what Trump has promised would increase debt, something that fiscally conservative Republicans will oppose. In short, it may not be smooth sailing, and investors are deluding themselves to think so.

“I think we should buckle in. I think there is going to be lot of volatility dead ahead,” cautions Mark Zandi, chief economist at Moody’s Analytics. “There is a lot being discounted in terms of tax policy, government spending and deregulation. I think that is going to be very difficult for them to nail down.”

Take Trump’s proposal to cut the corporate tax rate. That will have to be made up for — somewhere. One idea is to reduce corporate tax deductions. “Good luck with that,” says Zandi. Every deduction has beneficiaries with lobbyists who will resist losing the goodies.

Another proposed money raiser is the “border-adjustment tax.” It would put a big tax on imports, but none on exports, to encourage domestic production. That would be punishing for retailers who import a lot of what they sell, including big companies like Wal-Mart WMT, -0.45% Amazon.com AMZN, -0.28% Home Depot HD, +0.17% and Best Buy BBY, -0.25% which have the firepower to push back. “There is not going to be a straight line,” says Zandi. “I think there is going to be a lot of uncertainty.”

The timing: Obamacare reform is the key thing to watch near term, as Republicans are going to take a crack at it right away. Delay or failure might shake up the markets since this will be seen as a test case for Trump’s legislative prowess.

Risk No. 3: Populism

Donald Trump’s election marks a turning point in politics and economics no less important than the fall of the Berlin Wall, 9/11 and the global financial crisis, says Credit Suisse analyst James Sweeney.

That’s a bold statement. But it may not be far from the truth. Trump’s victory represents a rejection of the “old way” of doing things, motivated by populist sentiment among voters. In 2017, there will be more populism to come. And a lot of it could shake up your stock portfolio. A key area to watch for this is Europe.

Mainstream politicians face populist challengers in France, Italy and the Netherlands. The populists will probably lose, the “experts” on European politics tell us. But signs of strength along the way could rattle the markets, since many of them want their countries out of the European Union.

Both Marine Le Pen of the French National Front and Beppe Grillo’s populist Five Star Movement in Italy have called for an exit from the currency union. Any strength they show in election campaigns could signal an end to the EU. This could rattle investors just like Brexit did. And don’t rule out victories for those candidates. After all, the “experts” told us Brexit would get voted down, and Trump would lose.

The timing: Elections in France are in May and June. Dutch elections are in March. And Italian elections may happen in June.

Risk No. 4: China

China’s huge government debt, which reached nearly 270% of GDP in 2016, is a looming potential problem that could spark a financial crisis. That’s not likely to play out this year, say analysts at Goldman Sachs.

But China might still spark sell-offs. Besides the ongoing potential for heightened trade friction and military confrontations with the U.S. in the South China Sea, another potential catalyst looms.

This fall, the Chinese Communist Party will hold its 19th National Congress, a key meeting that will select much of the party’s Politburo leadership. President Xi Jinping isn’t going anywhere. He’s scheduled to exit office in 2022. But the meeting is important because it will go a long way to determining how China will manage issues like trade, currency levels, that looming debt — and Trump.

The timing: The meeting happens in the autumn, but the need to appear strong leading up to the event could make China’s president act more stridently in any of these areas, which could shake up the markets.

Risk No. 5: Trade Wars


Trump only recently became a politician, but he’s favored getting tough on trade for decades. His trade hawkishness dates back to the 1980s when Japan was the U.S. trade bugaboo.

More recently, Trump announced plans to create the White House National Trade Council (NTC) and appointed Peter Navarro to head it. This tells us Trump has no plans of letting up on trade. Navarro has written extensively about the need to retaliate with tariffs against trading partners who “cheat” with illegal export subsidies or currency manipulation, points out Barclays analyst Michael Gapen.

While tariffs on imports from China and Mexico might please voters, they could shake up the markets. That’s because they’d likely spark retaliation, says Daan Struyven at Goldman Sachs.

Likewise, the border-adjustment tax being kicked around by House Republicans may violate World Trade Organization rules. If so, it would likewise invite retaliation by trading partners. The bottom line here is that Trump’s tough stance on trade offers plenty of opportunities to spark a market sell-off. “He is serious about it,” says J.P. Morgan economist David Hensley. “The market is giving him the benefit of the doubt, but can he do it without being too disruptive?”

The timing: Trump is so adamant about trade matters, the issue could flare up at any moment.

Risk No. 6: Tweetin’ Trump Sparks A Geopolitical Crisis


Fed up with politics as usual, voters wanted a change in Washington, D.C., and that’s exactly what they got with Trump. He’s clearly signaled he may want to break with tradition in key foreign policy areas.

Trump has suggested he may abandon the U.S.’s “one China” policy, which sees Taiwan as part of China, if the country doesn’t play nice on trade and currency issues. Trump’s nominee for secretary of state, Rex Tillerson, has questioned Beijing’s land grabs of reclaimed reefs as territory in the South China Sea. Trump has also openly questioned why the U.S. has an outsized role in paying for the defense of NATO countries.

In another break with tradition, Trump loves to tweet over the heads of journalists and communicate directly to the public. Put the above two trends together, and it’s not farfetched to think that a late-night Trump foreign policy twitter storm could rattle the markets.

The timing: This could happen at any moment.

Risk No. 7: Investors Start To Think About Inflation As A Bad Thing


Since the financial meltdown, a major worry among market pundits has been deflation. They were wrong. It never happened. But given these widespread worries, investors are now complacent about the emerging signs that inflation is revving up, rather than worrying about it as they normally might. Because of the tight labor market, wage inflation ramped up to 2.9% in November, the highest level since 2009. Inflation itself remains fairly subdued, in the low 2% range depending on the measure. But that could change fast, given the tight labor markets.

What happens if inflation goes up more due to the tight labor market, and complacent attitudes about inflation shift to worry? That could be bad for stocks. It would have investors fearing more Fed rate hikes. It could be terrible for bonds. The last time the Fed got aggressive with rate hikes because inflation heated up, in 1994, bonds tanked, with some dropping over 25%.

No one knows for sure if inflation will rev up. But Trump’s plan to apply fiscal stimulus to an economy that’s at full employment might spark it, since companies might be forced to pay a lot more for workers and pass some of that expense on to customers, says Moody’s Analytics’ Zandi. “Stimulus when the economy is at 6% unemployment is one thing. It’s another at 4.7% unemployment. The transition to fiscal from monetary policy is not going to be graceful,” he cautions.

Timing: Hard to pin down. But investor attitudes can change rapidly, so worries about inflation could crop up any time this year.

Are You In The Icarus Trade?


The good news from Bank of America Merrill Lynch Global Research analysts is that stocks could have “one last 10% melt up” in the first half of 2017.

The bad news is that the same analysts call this the “Icarus trade.” As you recall, Icarus is the legendary mythological symbol of hubris who crashed after ignoring warnings and flying too close to the sun with wings made of feathers and wax.

These analysts say they are waiting for “unambiguous signs” of bullish investor positioning, bullish profit expectations, more hawkish Fed policy and outperformance among laggard assets before calling for “the big short.”


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