We’re already a month into New Year and there has been an
ample amount of sentiment data to suggest that investors, both retail and
institutional, aren’t terribly enthusiastic on the stock market outlook for
2017. Granted that institutional
analysts are still bullish, as per usual, but in the round table type opinion
polls I’ve seen they’ve apparently lowered their expectations. Everyone seems to be preparing for a somewhat
disappointing year based largely on the assumption that after eight years of a
bull market, surely another major rally is out of the question.
The decennial rhythm we discussed in an earlier commentary
argues against these diminished expectations.
Indeed, seventh year of the decade tends to be one of unusual volatility for
stock prices. While it’s true crashes, corrections
and panics are quite common in the seventh year (e.g. September 1987, October
1997, February/August 2007), the seventh year also sees a pronounced tendency
for sustained rallies in the first seven months of the year. Accordingly,
2017 could be a year filled with tremendous opportunity for making money in the
stock market – in both directions.
For 2017, the 10-year rhythm equates to
2007. As you recall, 2007 was a
momentous year characterized at once by great volatility alternating between
great fear and euphoria. It was the year
that saw the last major stock market top and also the onset of the credit
tsunami which overwhelmed the market the following year. If the decennial pattern holds true, 2017
should witness both a meaningful rally to new all-time highs as well as a
decline of potentially major proportions.
In short, it could turn out to be a big year for the bulls as well as
the bears.
As for the idea that the bull market is
getting “long in the tooth” and has therefore exhausted its upside potential,
consider that the previous two years could well be characterized as a stealth
bear market. The major large cap indices
essentially went nowhere in 2015-2016 while the Russell Small Cap Index (RUT)
experienced a 25% decline. That’s a bear
market by anyone’s definition.
Retail investors have also been quite pessimistic since 2015 in the
overall scheme of things. From the start of 2015 up until
the election, more than $200 billion was pulled out of U.S. equity funds and
ETFs, while a bit more than that was funneled into bond funds and
ETFs. That
two-year stretch of risk aversion, however, is apparently ending as investors
have gradually embraced more risk tolerance since the election. Since
the election nearly $46 billion has flowed into U.S. equity funds, while nearly
$3 billion has left bond funds, according to money flow statistics.
The evidence strongly suggests that the past
two years served the purpose of clearing out the excesses generated by the
long-term bull market which began in 2009.
In other words, the market is rested and ready to resume its potential
as we head further into 2017.
Another concern among investors is that the rise in interest
rates since last year could stifle the stock market’s upside potential. While
it’s true that sustained periods or rising Treasury yields have often proved a
hindrance to higher stock prices, there is an exception to that rule. According to
LPL Research, there have been 11 periods of rising interest rates (at least a 1%
rise in the 10-year Treasury note) since 1996, each lasting an average of six
months. During those times, the S&P
500 rose an average of 5.44%, thus proving that in the early stages of rising
interest rates stocks and yields often rise simultaneously.
We’re
at a point in the long-wave credit cycle where interest rates are ready to rise
after being depressed for years.
According to K-Wave theory, after the 60-year economic cycle bottomed in
2014 we should see a gradual increase in rates as the economy recovers its
former vigor. Of course this process
will take a long time to complete – possibly decades – but we’re likely at a
point in the newly formed 60-year cycle where even a temporarily sharp run-up
in rates won’t damage the economy or even necessarily hinder the stock
market. In fact, rising rates at this
point indicates increasing demand for credit and a corresponding improvement in
the economy.
Following
is a 10-year chart of the 10-year Treasury Yield Index (TNX). The double-bottom in the interest rate is
clearly visible between the years 2012 and 2016. I believe this marks the long-term low in
interest rates for the previous long-term cycle.
As
long as rates don’t rise too high, too fast it’s very possible that stock
prices will rise along with Treasury yields without much interference along the
way. An added bonus to the rally in
T-bond yields is that bond prices are now in a downward trend. This should serve to discourage investors who
piled heavily into the bond market in the last few years. It should also cause them to look more
closely at stocks as a long-term investment once again, especially as painful
memories from the 2008 crash gradually wear off. The underperformance of corporate debt
vis-à-vis equities should also encourage investors to take a second look at the
stock market. Below is the 1-year graph
of the Dow Jones Corporate Bond Index.
The bottom line is that 2017 should see an increase in business activity across the board as the U.S. returns to a normal business cycle after being artificially suppressed by the actions of central banks for years. Moreover, the decennial rhythm suggests that except for a period of potential weakness in the August-October time frame, year 2017 will likely prove to be a memorable one especially from the standpoint of the upside potential in both the equity market and the U.S. economy.
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