Can This Market Rally Continue

| About: SPDR Dow (DIA)

Summary

Fed Funds rate at zero for eight years has resulted in a tremendous amount of cash being held by banks.

Now that rates are going higher, a lot of that money will be coming off their balance sheet.

This could result in a boom followed by a bust, if the United States does not get good fiscal policy.

Much is being said about the "Trump" rally. True, some of this rally can be attributed to the election of Donald Trump. With a Republican Congress, there is a possibility for fiscal stimulus and looser regulations, which the stock market likes. However, I believe there is also another reason for the strong rally in stocks. We may be in the early stages of a Federal Reserve induced, boom period, that could lead to a bust.

It is important to understand, that central bank policy can make market moves smoother over the short term, but over the long term it can make them more volatile. Another consequence of central banking, is for money to be misallocated.

There is potential for misallocation in the stock market now. A lot of the money the Federal Reserve created since the 2008 financial crises, went into propping up the stock market. Stocks went up, despite tepid economic growth and an earnings recession, in recent quarters.

As the Federal Reserve kept rates low, banks began to hoard bonds. Now, as rates go up, and the banks are starting to dump those bonds, a lot of that money is also going into the stock market. Some of that may be justified. The S&P (NYSEARCA:SPY) has a P/E of about 25. The Dow Jones Industrial Average's (NYSEARCA:DIA) is about 22. A bit high, but considering earnings have been low and there are prospects of them going higher, it's not ridicules.

As rates go higher and the banks sell more bonds, it is likely that the stock market will go up even more. Raising the possibility for a bubble and setting the stock market up to crash.

Some Perspective

The chart below shows the Federal Funds rate vs. The Dow Jones Industrial Average from August 1971 until today. The United States ended the link between the dollar and gold in 1971.

An interesting comparison, is the year 1987 vs. 2007. In early 1987, the Fed had been raising rates. Then, In October of 1987, the market crashed, the Fed lowered rates, to provide liquidity to the market. It then began raising rates the following year. The market went up at a steady clip afterwards.

In 2007, the market crashed, the Fed also lowered rates to provide liquidity to the market. However, this time, it kept lowering them and kept them at zero for eight years. Money poured into the stock market and it has nearly tripled in that time.

I am not implying that 1987 was exactly the same as 2007. However, it seems like the Fed has overplayed it's hand. Rates need to go up. They said they will raise rates three times in 2017. Even with a dovish chairman, I think there could be more.

This leads into 1994. In 1994, the Fed raised the Fed Funds rate seven times. The market stabilized for a period, as it absorbed the rising rates. It then rallied.

Two bubbles, the internet and housing, precipitated a tripling in market value. This all ended as the Fed raised rates 17 times, from 2004 to 2006, to try and cool the housing bubble. The market crash in 2007 ensued.

To, illustrate how stock market valuation have moved, here is a historical chart of the S&P 500 P/E.

source:http://www.multpl.com

The P/E for the S&P 500 was about the same now, as it was in 1994. With anticipation of earnings growth, can the market go higher, like then, without the bubbles that lead to a 2007, or worse?

Fiscal Stimulus To The Rescue…

If there is fiscal stimulus, which allows companies to put all the money that is in the system, to work, I do believe that the stock market can go higher, longer term. I think short term, the market will stall the first few month of 2017, as the Fed raises rates. Then rally, as all that money is deployed into the market. Fiscal stimulus, in the form of tax cuts across the board, including corporations, as well as the rolling back the regulations that have impeded businesses from concentrating on investing capital, would help.

There is not a lot of room for error, considering the massive amount of debt the United States now holds. This has been a drag on the economy. Fortunately, congress has held the line on new spending in recent years, and the level of government debt stabilized.

Of course, the deficit would initially go up, if tax cuts are implemented. However, if businesses are allowed to invest that money, without the government impeding on them, the United States economy could grow, allowing that debt to be paid down. On the other hand, if the government does not concentrate on containing spending, the deficit could explode. In this case, the large debt level would be an even greater burden to the economy. In the first case the stock market goes up. In the second, a crash is inevitable.

To Summarize

The Federal Reserve has pumped a large amount of money into the United States economy. Now that they are raising rates, a lot of that money will begin to pour into the economy. Depending on how fiscal policy is implemented, there could be a long term bull market or a short term rally, followed by a market crash.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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