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Vroom! Stocks Jumpy on Fears of Over-Revved Economy

By John Persinos on February 13, 2018

Global growth is synchronized. America is poised to run deficits above 5% of gross domestic product. Huge tax cuts will soon kick in. Wage growth is taking off.

The result of this admixture? It’s like injecting too much nitromethane (i.e., rocket fuel) into a hot rod’s fuel tank. The engine will overheat. Inflationary fires will ignite, prompting the Federal Reserve to more aggressively raise rates. Historically, higher interest rates clobber stocks.

These fears roiled stocks Tuesday. The Dow Jones Industrial Average, S&P 500 and Nasdaq all plummeted in the morning, before rising in the afternoon to close modestly higher. Safe havens rallied.

Traders are trying to adjust to a new era of profligacy. President Donald Trump this week unveiled a $4 trillion-plus budget for next year that would double the deficit to $1 trillion. The proposed spending plan doesn’t come close to balancing the books even after 10 years. It funnels huge sums to an already well-funded Pentagon.

The tax overhaul Trump signed in December would add up to $1.5 trillion to America’s debt to pay for tax cuts. The majority of these cuts go to corporations already flush with cash.

President Trump said it himself. He called the tax cuts “rocket fuel” for the economy. He’s exactly right. And that’s why investors are jumpy.

The CBOE Volatility Index (VIX), aka fear gauge, started this month at a relatively calm 14. Today it closed above 25. The silver lining: volatility is paradise for options traders.

But the fact is, massive stimulus is being applied to conditions that don’t need it. The government should stomp on the gas pedal during recessions, not expansions. When a recession actually hits (and we’re overdue for one), policymakers will have fewer means to rev-up the economy.

Economic growth is robust in North America, Europe and Asia. The U.S. is close to full employment, with accelerating wage growth. Investors now fear inflation, not stagnation. Hence Tuesday’s stock market gyrations. Stocks rose for the third consecutive session, but trading was choppy.

The latest Consumer Price Index (CPI) numbers arrive on Wednesday. Wall Street is nervous. If the CPI for January comes in higher than expected, stocks tomorrow could fall off a cliff.

Think the correction is over? Nope. Despite recent steep plunges, U.S. stock prices have dipped to where they were at the beginning of the year. That means share prices remain overvalued.

As inflation rears its head, 10-year Treasury bond yields have risen from below 2.1% in September to nearly 2.9% today. Healthy corporate profits would seem to justify higher share prices, but bond yields are rising, too. Higher bond yields depress the value of those earnings and make sky-high valuations harder to justify.

The bear of yesteryear…

The stock market collapse of the early 1970s is instructive. By 1968, economic growth and the stock market had been rising, with only minor hiccups, for two decades. Prosperity would continue until the 1973-1974 bear market, when stocks across the board got crushed.

What triggered this bear market? The federal government was paying for Great Society social programs, while at the same time spending vast sums to fight the war in Vietnam. All without raising taxes. The Arab oil embargo also played a role, by hiking energy costs. The Watergate scandal brought political risk.

Inflation (as measured by the Consumer Price Index) spiked from 3.4% in 1972 to 12.3% in 1974. A recession hit, spawning stagflation.

The Dow had enjoyed a great year in 1972, with gains of 15% in those 12 months. As 1973 got underway, the conventional wisdom was that stocks would do even better. Time magazine reported in January 1973 that the new year was “shaping up as a gilt-edged year.”

A mere three days after the magazine’s bullish pronouncement, the crash began. Between January 11, 1973 and December 6, 1974, the Dow lost over 45% of its value.

Now ask yourself: could you afford to lose 45% of your portfolio?

Don’t get lulled into complacency by the cheerleaders on CNBC. These folks are always on puppy uppers. Reduce your exposure to momentum stocks. Keep plenty of cash on hand. Maintain an ample allocation to hedges.

Sensible portfolio allocations right now are 35% stocks, 35% hedges, 20% cash, and 10% bonds. Exact percentages depend on your particular circumstances. We’re probably facing a rough year — a year that might make you wistful for 2017.

Tuesday Market Wrap

  • DJIA: +0.16% or +39.18 points to close at 24,640.45
  • S&P 500: +0.26% or +6.94 points to close at 2,662.94
  • Nasdaq: +0.45% or +31.55 points to close at 7,013.51

Tuesday’s Big Gainers

Vitamin retailer gets big investment from Chinese drug firm.

Sportswear retailer beats on earnings.

Small business lender issues solid earnings.

Tuesday’s Big Decliners

Biotech’s clinical trials disappoint.

Anti-trust allegations hit pet care firm.

Med supply firm threatened by Amazon (NSDQ: AMZN).

Letters to the Editor

“Trump proposes to boost infrastructure spending. Does that make construction stocks attractive?” — Peter A.

Not necessarily. Trump’s plan is not a latter-day version of FDR’s Works Progress Administration. It’s really a privatization plan.

Rather than increase federal spending, Trump’s plan would provide tax breaks for firms to forge state-local partnerships. A major goal is the construction of more privately-operated toll roads.

The common assumption is that big construction and engineering firms are “Trump plays.” But select companies would get the goodies. Some of these firms fly under-the-radar.

Before you jump into the construction sector, wait to see how the proposed infrastructure program pans out. It faces tough opposition from Republicans as well as Democrats.

Questions about deficit spending and how it affects your investments? Drop me a line:

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


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