After a Torrid Start to 2018, Markets Hit the “Pause” Button

I’m an avid skier. While riding a chair lift the other day, my buddy sitting next to me pulled his smartphone out of his parka. “This app allows me to trade Bitcoin while I’m on the slopes,” he exclaimed with pride.

I saw it as a terrifying contrarian indicator.

Many investors have only known low inflation, low interest rates, and a bull market. These conditions can’t last forever. Perhaps this reality hit home Monday.

The major indices closed mixed on Monday. The Dow posted its first decline of 2018. The S&P 500 and Nasdaq eked out meager gains. Throughout the day, the markets were treading water.

The fourth quarter earnings season kicks off this week. Banks top the list. Until report cards come in, traders are pocketing gains. They’re waiting for the next catalyst.

According to FactSet, the estimated year-over-year earnings growth rate for the S&P 500 in the fourth quarter is 10.5%. All eleven sectors are expected to report earnings growth. The estimated revenue growth rate for the quarter is 6.7%.

The energy sector in Q4 is expected to report the highest earnings growth of all sectors at 132.7%. Energy’s outsized growth stems from rising oil and gas prices, plus exceptionally low earnings in the year-ago quarter.

Stocks remain overvalued. The forward 12-month price-to-earnings (P/E) ratio is 18.4. This P/E ratio is above the 5-year average of 15.9 and above the 10-year average of 14.2. What can justify lofty valuations? Strong earnings. That’s the hope, anyway.

The verdict on tax cuts is out. As I’ll explain, cutting taxes during an expansion could prove a double-edge sword.

On the economic blackboard…

On the docket this week: Small Business Optimism Index (Tuesday); Mortgage Applications (Wednesday); Jobless Claims, Consumer Comfort Index (Thursday); Consumer Price Index (CPI), Retail Sales, and Business Inventories (Friday).

Keep an eye on the CPI. Investors have forgotten how inflation can ravage their wealth. It currently runs slightly below 2%, but don’t get complacent.

After the 2008 crash, central banks threw open the monetary spigots. Easy money lifted the world out of crisis. We barely averted a total meltdown of global capitalism. Memories of this trauma are fading.

Today, households are confident. Median household income grew by 5.2% in 2015 and 3.2% in 2016. The Labor Department reported last week that average hourly earnings are growing.

The news seems good across the board. House prices are rising. Unemployment is falling. Stocks are booming. Businesses are spending. Consumers are buying.

But into this happy mix comes tax cuts — $1.5 trillion worth. The recovery is nearly nine years old. Stimulus at this late stage in the economic cycle could be too much of a good thing. The economy could overheat.

Overseas economies could overheat, too. All regions are thriving. China remains the world’s growth engine. But the Middle Kingdom is showing cracks. China’s infrastructure spree exploded the country’s deficit. “Zombie” firms feed on hand outs. The middle class wants higher pay.

Low interest rates have fostered asset bubbles. The Fed tries to strike a balance between the twin dangers of recession and inflation. The margin for error is shrinking.

It took a decade of ultra-low rates to get economies back on their feet. The magnitude of this stimulus is unprecedented. The seeds of inflation are sown. If the Fed sees fit to raise rates more than expected this year, it could trigger another crash. We’re entering uncharted waters.

We’ll know more when we see this week’s CPI data. If inflation flares and earnings falter, stocks could stumble. The exact starting point of a correction? There’s no app for that.

Monday Market Wrap

  • DJIA: -0.05% or -12.94 points to close at 25,282.93
  • S&P 500: +0.17% or +4.56 points to close at 2,747.71
  • Nasdaq: +0.29% or +20.83 points to close at 7,157.39

Monday’s Big Gainers

  • Vuzix (NSDQ: VUZI) +12.42%

Smart glasses maker rallies on new product.

  • Seagate Technology (NSDQ: STX) +7.13%

Analysts bullish on data storage firm’s cryptocurrency foray.

  • 22nd Century Group (NYSE: XXII) +5.47%

Marijuana biotech soars as AG threats flop.

Monday’s Big Decliners

  • Micro Focus International (NYSE: MFGP) -16.64%

Merger with Hewlett Packard Enterprise (NYSE: HPE) fares poorly.

  • Daqo New Energy (NYSE: DQ) -13.85%

CEO quits polysilicon maker.

  • Five Oaks Investment (NYSE: OAKS) -10.88%

REIT cuts dividend.

Letters to the Editor

“I have a $350,000 portfolio and I am 93! I do not understand options. My two daughters are not investors. I am in good health but I worry about the coming correction.

The stocks I hold are in good companies but because of my age I wonder whether I should sell everything and stop investing. This is difficult to decide. I don’t want to lose and not live to recover what I’ve worked so hard to acquire. What say you to someone in my position?” Grace H.

Don’t dump stocks. Stay in the game. Even in these dicey conditions, a source of safe income exists, if you know where to look. As you alluded to in your letter, the place to look is options.

Don’t get spooked. Options trading is easier than it seems. With simple options strategies, you can secure your retirement.

As 2018 gets underway, we face many questions. Will tax cuts overheat the economy? Will firms use the cash to create jobs or boost bottom lines? Will recovery lapse into recession?

Now is an opportune time to consider options strategies that generate income and hedge your portfolio. I explain in detail how to use options in my December 28 issue of Mind Over Markets.

Got questions about protective strategies? Shoot me a letter:

John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.