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Stocks Are Long Overdue Major Correction

From Bill Hall: As we close in on the heart of the holiday season, the U.S. stock market finds itself filled with happiness and joy, riding the wave of the often referred to Trump Rally. Indeed, the U.S. stock market as measured by the benchmark S&P 500 has gained approximately 5.5 percent, setting numerous records along its jolly move upward.

This surprising and dramatic rise has everyone asking: “How much higher can we go?”

While I have no idea (and neither does anyone else with any degree of intellectual integrity) what the market is going to do in the near term, I have pointed out in my two most recent Money and Markets articles that there are some sizable macro-economic challenges awaiting President-elect Trump and his new administration. These troubles revolve primarily around slow global GDP growth caused by an over-indebted world, systemic demographic issues and a limited economic toolbox that’s already been picked over by the world’s central bankers.

But there are two main pillars of Trump’s economic policy that seem to have caught the fantasy of the stock market and equity investors during this holiday season. First is his tax reform policy and the second is his program for fiscal stimulus with an emphasis on infrastructure spending. Let’s drill down and take a look at these so we can get a sense of the potential impact of each.

Personally, the most potentially dramatic component of Trump’s policy is the reduction in tax rates. When you add it all up, the Trump plan calls for a $500 billion decrease in taxes over the next 10 years, which some economists have estimated could add $100 billion a year to U.S. economic growth. That would be an impressive, eye-opening and meaningful increase in annual output from the U.S. economy.

While $100 billion is indeed a big number, it’s not nearly as large — in relative terms — as the Reagan tax cut in the early 1980s was supposed to yield. What’s more, the Reagan tax cuts were implemented during a period of economic malaise and sharply falling interest rates. But even with these factors creating a favorable tailwind, the U.S. economy was still slow to respond to Reagan’s tax plan.

Now consider that the U.S. economy is in the midst of a 6 ½ year expansion — yes, it’s been a sputtering hit-and-miss recovery, but it’s been an expansion nonetheless. This means that the pent-up demand for virtually all big-ticket items is likely exhausted. That’s apartments, single family homes, new vehicles and plant and equipment.

If you are seeking proof, look no further than the data coming from the auto industry that shows vehicle sales for the first 10 months of this year have fallen slightly behind last year’s pace and that new and used car prices are down 1.2 percent over the past year.

All this means that — yes, there’s hope for the Trump tax policies to provide an economic boost, but it’s far from certain because it’s going to be a tough hill to climb.

Now, for a closer examination of the second part of Trump’s plan: Fiscal stimulus focused primarily on infrastructure spending. To dig deeper on this one, I’ve included a chart from Goldman Sachs’ Chief Economist Jan Hatzius.

Generally, this chart shows that over the short term, according to Hatzius, Trump’s policies should boost U.S. GDP at the expense of global growth, particularly in emerging markets. The reason for the short-term boost and then the longer-term decline is a lengthy and multi-layered explanation that needs to be deferred to a separate article but results primarily because increased government spending comes at the expense of more productive private sector spending.

Nonetheless, in summary, the second cornerstone piece of Trump’s economic policy — fiscal stimulus through infrastructure spending — is short-term positive and long-term negative according to Goldman Sachs. If the chief economist at Goldman Sachs is concerned, it’s enough to raise a red flag in my mind. Hatzius, and other economists who share his views, may not be precisely right but — in my view — there’s enough to their analysis that I consider it a warning sign that I should pass along to the investors that I advise.

To sum it all up: In my opinion, there’s hope that the Trump tax policies generate meaningful GDP growth but there’s not so much optimism for the fiscal spending part of his plan.

Making things even far more difficult for a Trump administration is that in the last 100 years, there has never been a two-term presidency end that wasn’t followed, within 12 months, by a recession. But we do live in interesting times and it’s possible that the world’s central banks make good on their promises to double down on their experimental economic policies in a way that will kick the can down the road on a recession.

What does all this mean?

There’s plenty of uncertainty surrounding President-elect Trump and his policies — and in the financial markets, uncertainty equates to volatility. In fact, I expect frequent stock market swings of as much as 20 percent or more — both up and down — as the financial markets react to Trump’s unconventional policies. That’s not to say the President-elect’s approach is good or bad; it’s simply the fact that it’s inherently unpredictable that will cause dramatic financial market volatility.

In closing, here’s something you should know. Ned Davis Research reports that it’s been 1,955 days — that’s about 5 ½ years — since the U.S. stock market suffered a 20 percent decline or more.

To put this in perspective, Ned Davis says that since 1928, the average number of days before a correction of more than 20 percent occurred was 635 (or every two years or so). For those even more detailed: In secular bull periods the average number of days was 1,105. In secular bear periods, the average number of days was 486.

That means that the current case of 1,955 days without a correction of at least 20 percent is MORE THAN THREE TIMES THE AVERAGE. And that’s for the entire period from January 3, 1928 to December 8, 2016! Now, for those concerned about our nest eggs, that’s worth a moment of holiday reflection.

Check back next week, when I’ll explain why I say “let us all join hands and exclaim, ‘Thank you, Fed, BOJ, and ECB!’ for this record number of days without a 20 percent down draft.” And I’ll reveal the key valuation indicators that I am watching that make me wonder how much higher the U.S. equity market can go without faltering.

The iShares S&P 500 Index (ETF) (NYSE:IVV) was unchanged at $226.85 in premarket trading Friday. Year-to-date, the second largest ETF tied to the S&P 500 index has gained 11.48%.

IVV currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #2 of 108 ETFs in the Large Cap Blend ETFs category.

This article is brought to you courtesy of Money And Markets.

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