The Stock Market In 2018

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Includes: VOO
by: John M. Mason

Summary

2017 has been an incredible year for the stock market with new historical highs coming almost all the time.

However, according to the CAPE measure, the market has reached a level that is third highest, historically, and is within striking distance of the second highest level reached in 1929.

The euphoria of the past eight years has been generated by an overly generous Federal Reserve, which has now been augmented by a tax bill from an overly generous Congress.

The question is, can the stock market euphoria be continued for another year?

I believe that the US stock market is overvalued. On January 4, 2017, I wrote: “I believe that the stock market is overvalued and will face a correction sooner rather than later.”

Whoops! I am still in the same place I was last year.

Looking at Robert Shiller’s Cyclically Adjusted Price Earnings measure (CAPE), we see that currently CAPE is at 32.44. This is the third highest level that this measure has ever reached.

And, guess what? In September 1929, just before the stock market crash, the CAPE measure was at 32.56. A good day today will see the current level of CAPE moving into the second slot.

First place goes to December 1999 when the CAPE measure hit 44.20. CAPE always reverts to its historical mean, but what does the above information say about stock market corrections?

Shiller’s measure of CAPE never says anything about timing. All we can say is that the stock market seems to be overvalued and someday there will be a correction

The thing is, the stock market seems to have a mind of its own and appears to be more of a Bitcoin phenomenon and not something based on any valuation model I know of. Over the past eight years or so, I have suggested that the ever increasing stock prices were based on the mantra: follow the Fed.

Ben Bernanke, former Fed Chair, created a monetary policy aimed at creating a wealth effect due to rising stock prices so as to stimulate increases in consumer spending. He succeeded and this produced the foundation for the economic recovery. Soon-to-be-former Fed Chair, Janet Yellen continued the policy.

But market participants also understood that Mr. Bernanke and Ms. Yellen also emulated former Fed Chair Alan Greenspan by creating a “put” under the stock market. That is, the Fed of Mr. Bernanke and Ms. Yellen always acted to err on the side of monetary ease so as to avoid the possibility that there might be some banking disorder that would upset the recovery.

They were obviously very successful. The stock market has performed up to the present time trusting in the underwriting of the Federal Reserve’s monetary policy.

Even with increases in its policy rate of interest over the past three years, there has been plenty of liquidity in the banking system. For example, if one looks at the rate of growth of the M2 measure of the money stock, one sees that over the past five years, the M2 money stock has grown a 6.1 percent from November 2012 to November 2013; 5.8 percent the next 12-month period; 5.9 percent ending in November 2015; 7.3 percent ending in November 2016 and 4.7 percent ending in November 2017.

These are pretty ample growth rates. Furthermore, if one calculates similar growth rates for more expanded measures of the money stock or the money stock plus different measures of credit, one finds that the growth rates are even higher.

Credit inflation reigns!

Adding to this, we got the Trump election in November 2016 and Mr. Trump’s promise of tax cuts, infrastructure spending, and reductions in regulations have provided even more fuel to the stock market making the year 2017 a banner year as far as hitting new historical highs for the market.

Right now, the stock market is riding the wave of euphoria connected with the actual passage of the tax cut bill. But, how much more steam can be added to the market?

It seems as if a majority of economists believe that the tax cuts will provide very little new growth to the economy, with economic growth rising up to a year-over-year rate, maybe of 2.5 percent in the short-run, but dropping off after that.

Furthermore, there is added talk about all the adjustments and re-writes that must be added to the bill once the bill is passed. Seems as if the construction of the tax cuts were done somewhat sloppily.

And, there is an expected huge increase in the government debt load because of the tax bill. The sight of this is causing some people to argue that further adjustments to entitlements and other “liberal” parts of the government’s programs will have to be cut back in future years to reduce the expected deficits.

Then we could add lots more to the picture of the forthcoming year… North Korea, the Middle East, China, Europe, and so on.

This is the 2018 we are now entering. Lots of euphoria - but, lots of uncertainty, disequilibrium, and disjointedness. It seems as if a lot of the pieces of the puzzle just don’t seem to fit.

One cannot tell when a stock market downturn might take place, but prices are awfully high. For example, the CAPE measure still has a ways to go to match the level attained in December 1999, which was achieved just before the 2000 stock market correction. The current rise could go on for months now.

I have already suggested that one needs to watch the bond market closely in 2018. One reason for this is that the bond market may react to changes at the Federal Reserve faster than any other area of the economy. The Federal Reserve is on new ground; it has never done what it is attempting to do now. And, the Federal Reserve is getting a new chairman and five other new members this year.

To conclude, let me say again that I believe that the stock market is overvalued. Where we go from here and when is still just a guess. There are no models to capture the current situation.

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.