Stocks Drifting into the New Year … What will 2018 Bring?

Stocks have been drifting sideways amid light volume holiday trading. The Dow and S&P notched new record highs on December 18, and have been in a fairly tight trading range ever since; a typical year-end pattern for markets.

This is happening against a backdrop where retail investors are increasingly throwing money into stocks with reckless abandon.

In fact, we’re witnessing record inflows into U.S. stocks to the tune of nearly $8 billion during the week ended December 13 alone. The biggest cash inflows in six-months. And large-cap tech stocks have been enjoying most of the buying, with the largest inflows in nearly nine months!

It has all the hallmarks of a classic buying panic with investors finally leaving the sidelines to go all in … with stocks already trading at nose-bleed valuations.

Ah, but conditions can get even more irrational than most think possible during a classic market melt-up phase. In fact, historically between 40% and 50% of an entire bull market move can occur in the last 24 months alone, with stocks often gaining 50% or more.

This is the dynamic that’s driving the cycle inversion we’re witnessing as the Dow and other indexes accelerate higher instead of rolling over as the cycle forecasts suggest.

So, what can derail this bull market and when?

Early 2018 trading should provide important clues. Typically, money flows into the markets early in the new year. So, keep a watchful eye on fund flows as 2018 begins. And if these money flows are conspicuously absent, watch out!

Another factor that you should follow closely is the underlying strength of the U.S. economy.

2017 is ending on a high note for our economy, as you can see above. The tax cuts will only help juice growth even more in the months ahead. In fact, recent economic survey data points to GDP growth of perhaps 5% to 6%!

Growth that fast carries with it several negatives, however.

First, producer price inflation is already building in the business supply chain, but hasn’t shown up in the woefully inaccurate consumer price inflation (CPI) data. At least not yet.

Second, when, not if, inflation shows up – first in the Producer Price Index, then the CPI – the Fed will find itself up a creek without a paddle, hopelessly behind the curve of accelerating inflation.

This will no doubt force the Fed’s hand in raising interest rates much faster next year than investors now expect … which is NOT good news for stock prices. Remember, it’s typically the Fed that kills off bull markets with aggressively tight money.

Third, keep a wary eye on bond markets, because that’s where the damage will be done first, before selling hits stocks. Faster rate hikes mean higher yields across the fixed income spectrum.

It will hit junk bonds first, and hardest. That’s because if you think stocks look expensive today, it’s nothing compared to the excessive valuation for high yield bonds both here and in Europe.

Remember, the single biggest threat to bonds … isn’t too much debt or growing deficits … it’s inflation, which will destroy the meager yields bond investors are getting today.

Bottom line: The key to investment success in 2018 will be to watch money flows like a hawk. Flows into stocks, yes, but more importantly watch flows into … or more likely out of, bonds … as the first sign of trouble ahead for markets.

Good investing and Happy New Year,


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