Markets May Party All the Way Into 2018

U.S. equities melted higher again on Monday, pushing the Dow Jones Industrial Average to its 70th record close for the year (something it has never done before) as price momentum pushes to its most overbought level since the 1950s.

There have been no down months since President Trump was elected. And as things stand now, 2017 is shaping up to the first-ever “perfect” year without a monthly decline.

It simply doesn’t get better than this as sentiment remains white-hot as the GOP tax cut plan moves to fruition.

In the end, the Dow Jones gained 0.6%, the S&P 500 gained 0.6%, the Nasdaq Composite gained 0.8% and the Russell 2000 gained 1.2%. The Nasdaq crossed above the 7,000 level for the first time. Lots of superlatives.

steel stocks

Materials stocks were on the move, with steelmakers in particular looking strong. The VanEck Vectors Steel ETF (NYSEARCA:SLX) gained 2.7% with Unite States Steel Corporation (NYSE:X) up 5%. Big-cap tech stocks were on the move as well, with Apple Inc. (NASDAQ:AAPL) up 1.4% to push to a new high.

aapl stock

But as stocks (and Bitcoin) prices reach for the sky, other markets are struggling. China’s Shanghai Composite was down again overnight and it remains well off of its recent highs. Furthermore, it is on the verge of closing below its 200-day moving average for the first time since June.

Remember: While everyone here is focused on tax cuts here at home, Chinese markets are being pressured by the tightening of dollar-based liquidity as a result of the Federal Reserve’s interest rate hikes, threatening to undermine its bad-debt house of cards.


Looking around, there is plenty of evidence animal spirits are in full force. The latest Flow Show report from Bank of America Merrill Lynch showed U.S. equity inflows totaled nearly $8 billion for the week ending Dec. 13 — the largest in 26 weeks. Large-caps saw their largest inflows in 33 weeks. Value stocks enjoyed the largest inflow in 36 weeks.

There could be more upside, with UBS strategist Keith Parker estimating earlier in the week that just 40% of the tax cut has been priced into stocks with expectations for a surge in M&A and buybacks likely to follow actual passage of the legislation. Analysts from Credit Suisse and JPMorgan echoed this sentiment.

Separately, the NFIB survey of small businesses showed the second-highest level of optimism in the 44-year history of the index and the highest level in 34 years. And with Bitcoin surging towards the $20,000-level on Sunday, enthusiasm is so thick in the air you could cut it, bag it, and sell it on eBay.

What then, if anything, should investors be watching for heading into 2018 as possible party spoilers? According to a growing consensus on Wall Street, some combination of inflation, more aggressive Fed tightening, bond market turmoil, and a downturn in China.

Producer price inflation is building in the supply chain based on recent data, but it has yet to show up in the consumer-level data. That could soon change, with Bank of America Merrill Lynch analysts noting that survey data — including small businesses, manufacturing, homebuilders and consumers — are consistent with GDP growth surging to 5%-6%.

This would come at a time when the economy is already running near its full capacity, with the post-recession potential GDP deficit now closed and the job market near maximum. Inflation is the likely result, forcing the Fed into a more aggressive tightening path than the market currently expects, with just three quarter-point hikes expected over the next three years.

GDP chart

Faster Fed tightening would turn off the flow of global dollar liquidity, which would hurt Chinese borrowers with loans in dollars. Moreover, the People’s Bank of China has lately been shadowing the Fed’s rate hike path in an effort to keep currency volatility low. But that’s causing inter-bank lending rates to spike to worrisome levels.

Higher yields will hit junk bonds hard, with valuations frothy. In Europe, interest rates are actually below comparable Treasury bonds, which is incredible. According to research by the Bank of England, since 1925 the single largest driver of bond market turmoil isn’t fiscal deficits or faster economic growth: It’s inflation.

I’ll distill it down to this: Keep an eye on inflation and junk bonds, tracking relevant ETFs like SPDR Barclays Capital High Yield Bnd ETF (NYSEARCA:JNK) and iShares iBoxx $ High Yid Corp Bond (ETF) (NYSEARCA:HYG) in 2018. These will be the canaries in the proverbial coal mine.

Check out Serge Berger’s Trade of the Day for Dec. 19.

Today’s Trading Landscape

To see a list of the companies reporting earnings today, click here.

For a list of this week’s economic reports due out, click here.

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Anthony Mirhaydari is the founder of the Edge (ETFs) and Edge Pro (Options) investment advisory newsletters. Free two- and four-week trial offers have been extended to InvestorPlace readers.

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