Can We Expect a Sharp Stock Market Drop?

Last year, almost everyone was bullish on the stock market. This year, everything has changed.

The stock market remains volatile, and caution is in the wind.

Michael Zezas, Morgan Stanley’s chief US public policy strategist, has sounded the alarm bells and wrote on the weekend:

We’re pushing back on the notion that US policy actions have meaningfully extended the market cycle, instead arguing that markets have already largely reflected, and are currently pricing in, the benefits they delivered.

Zezas believes US President Donald Trump’s tax cuts are priced into the market. The President slashed the corporate tax rate from 35% to 21%, earlier in the year. That helped boost investor sentiment.

But corporate tax cuts can only do so much for share prices.

I’ll explain…

What do tax-cuts mean for the stock market?

There are various thoughts on ‘trickle down economics’. The proponents believe corporate tax cuts will get passed ‘down’ through the economy. If a company has larger profits, it’s likely to increase wages and therefore stimulate spending. That should re-boot the economy and lead to more economic growth, opportunities and higher profits.

I used to agree.

But not anymore.

Corporations are greedy.

OK, some companies handed out bonuses to long-term employees. But most said, thank you for the tax cuts. Most corporations couldn’t care less about their employees. That is, unless you’re a big fish in the food chain.

It’s that simple.

Corporate tax cuts should result in larger profits. But that’s likely to only benefit high-level employees and shareholders.

Most high-level employees tend to be conservative. They generally don’t go out and start businesses. Instead, they want to climb the corporate chain. And invest their extra earnings into their retirement funds and the stock market.

It’s a self-fulfilling prophecy.

Shareholders, meanwhile, are likely to do the same. Very few people take money out of the stock market. It’s generally seen as a wealth building avenue. In other words, corporate tax cuts probably won’t stimulate the economy. But they are likely to drive stock prices higher. And that begs the question: How high can stocks go?

It’s debatable…

What can we expect from the stock market?

Some punters believe that stocks are due for higher highs. But the majority are starting to think we’ll see lower prices. Mike Wilson, Morgan Stanley’s chief US equity strategist, told clients that January may have marked the market top for the year.

CNBC reported on his note yesterday:

With volatility moving higher we think it will be difficult for institutional clients to gross up to or beyond the January peaks…Retail sentiment indicators also look to have peaked in January and we do not see anything on the horizon to get retail investors more bullish than they were following a tax cut.

Back in January when stocks were rising sharply, we heard numerous calls for a “melt-up” being made by prognosticators and investors…Of course, that’s how tops are made and we think January marked the top for sentiment, if not prices, for the year.

When we look at our internal data combined with industry flows and sentiment, we think there is a strong case that January was the melt-up, or at least the culmination of it.’

Wilson seems on the money.

The CBOE volatility index (VIX) — widely considered the best gauge of fear in the market — hit 8.56 last year. That’s a record low. In February, when the stock market dropped sharply, the VIX rocketed to 50.30.

The VIX is trading around 20 today. It can’t fall back below the key 15 level. Put simply, volatility remains elevated.

More importantly, US interest rates are on the rise. The US Federal Reserve is likely to raise interest rates tonight. But the big question is, will interest rates rise three or four times this year?

We’ll know tomorrow morning.

A bullish Fed could make market pundits nervous in the months ahead. There’s little news on the fiscal policy front to drive prices.

Liquidity is getting tighter, as well.

Two-year US yields are at the highest since before Lehman Brothers collapsed.

The London Inter-bank Offered Rate (LIBOR) — the lending rate between banks — is rising. That suggests dearer funding costs.

Pay attention to the 10-year treasury yield. There’s a risk that when it breaks the 3% level, the stock could see another sharp drop. It’s trading at 2.859 % today. The 10-year bond is used as a proxy for multiple loan agreements, such as mortgage rates.

The 3% yield level signals the bond bull market is over. That could impact investor confidence and lead to more volatility, and another sharp dip in the stock market. In other words, considering freeing up some capital. The best stocks might get a lot cheaper, soon.

Regards,

Jason Stevenson,
Resources Analyst, Gold & Commodities Stock Trader


Jason Stevenson is Markets & Money’s resource analyst. He shares over a decade’s worth of investing and trading experience across resource stocks and commodity futures and options. He originally studied accounting and finance at Curtin University, where he was awarded a first-class honours degree. His professional background stems across high-net-worth, top tier accounting (corporate finance, tax and auditing), and sell-side equities research. Before joining the team at Markets and Money, Jason worked at boutique firms which advised fund managers and high-net-worth clients on where to invest. Whether it’s gold, crude oil, copper or an obscure metal like vanadium, you can rely on an in-depth analysis in Markets and Money. Jason also brings you extensive macro, political and geopolitical analysis from around the world. He leaves no stone unturned when it comes to telling the truth. Jason is also the lead analyst of Gold Stock Trader, a premium service for investors serious about precious metal stocks. Websites and financial e-letters Jason writes for:


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