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Let the Good Times Roll

By Jim Pearce on July 28, 2017

We’ve all heard the old joke about the airline pilot who announces to his passengers that unfortunately he is lost, but the good news is they’re making very good time.

This type of contradictory behavior is sometimes referred to as “cognitive dissonance,” and I’m noticing more of it as investors keep pumping money into exorbitantly priced momentum stocks.

I was reminded of that on July 26, when the Federal Reserve announced it would leave interest rates unchanged for the time being and affirmed its conservative “dot plot” of future rate hikes due to lessening concerns over inflation. That’s good news for bondholders, but if inflation is tied to economic growth, it’s fair to ask what that news portends for shareholders that participate in corporate profits via rising dividends and higher equity values.

It appears most investors are willing to look the other way. Boosted by strong second-quarter earnings reports from longtime stalwarts McDonald’s (NYSE: MCD) and Caterpillar (NYSE: CAT), the Dow Jones Industrial Average surged to a record high the same day the Fed made its announcement. It’s heartening that sexy tech stocks aren’t the only strong performers these days, especially since many of those companies are already grossly overvalued.

However, the wave of bigger-than-expected profits across all sectors of the economy suggests the Fed may need to raise interest rates more than it’s letting on. Employees at companies like McDonald’s and Caterpillar will demand higher wages, which in turn will spur inflation as that money is spent on the types of goods that comprise the consumer price index.

That dynamic won’t happen overnight, but gradually the data will dictate that either the Fed must raise rates faster than most people think, or earnings won’t be able to grow at a sufficiently robust pace to justify current stock market valuations.

Either way, sooner or later the small group of momentum stocks that have been leading the market higher will face their day of reckoning. It may not be next week or next month, but when it happens it will seem all too sudden.

Until then, a lot of fast money can be made in this stock market, and you don’t have to go looking in out-of-the-way places to find it. Shares of social media behemoth Facebook (NSDQ: FB) spiked 5% in one day after releasing another strong earnings report. Netflix (NSDQ: NFLX) stock did much better than that, jumping more than 10% on July 18 after releasing its quarterly report.

Exactly how, and when, all this unbridled optimism comes to an end is impossible to say, but sooner or later the incongruity of higher future earnings expectations and lower economic growth projections will have to be rectified.


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