Stock market risk is higher for 2017

Behavioural finance analyst Ken Norquay makes the case that stock market risk is higher than normal as 2017 begins and advises investors to hold lower-than-normal amounts of stocks and bonds and higher-than-normal cash reserves including alternative assets such as gold, gold coins or precious metals mutual funds.

In the investment business, forecasts are always persuasive arguments telling us all why investing is still a good idea. In my stock market book, Beyond the Bull, I observe that persuasive reporting can never be objective truth. Persuasive reports are always one-sided presentations designed to persuade the reader to become or remain a customer of the economic writer’s employer. The financial markets are determined by investors’ collective attitudes and beliefs. Optimistic annual forecasts are a wonderful way of helping investors maintain their positive and hopeful attitude.

New Year’s resolutions are quite another story. Our resolutions reflect what we think of ourselves, and how we’d like to improve our lives. Investors seldom make a New Year’s resolution to do nothing. “I resolve to continue to buy high-quality stocks and hold them for the long term,” is rarely a New Year’s resolution. Investors’ New Year’s resolutions usually involve taking action.

I recommend that investors resolve to make an investment plan that involves both buying and selling stocks. Buying opens the door to making a profit; selling closes the door to incurring a loss. Buying investments exposes us to risk and reward; selling eliminates risk and reward. The old stock market saying, ‘buy low, sell high’, reflects this simple, elegant wisdom. Our investment plans should reflect it too.

Safety first

I am continuously critical of the investment industry’s focus on buying alone, as it exposes people to risk and reward without the offsetting selling, which removes risk and reward. In general, the cumulative effect of this misplaced emphasis is that many people come to be much more at risk than they should be. It seems appropriate for me to recommend New Year’s resolutions that emphasize safety.

Those who write stock market forecasts sometimes refer to two long-term statistical studies—the decennial pattern and the presidential election pattern. I doubt that you will read much about these two studies in January 2017, because most stock market analysts have a bullish bias—they always try to persuade us that the stock market will continue to move upward. But, according to the decennial pattern and the presidential election pattern, 2017 could be a negative year.

The decennial pattern

Briefly, the decennial pattern refers to a 10-year cycle in the stock market. The analyst compiles statistics about whether each year was an up year or a down year. In the period from 1900 to 2010, years ending in ‘7’ often contained stock market tops. But in my short career, 1977 saw a 10 per cent loss, 1987 contained the biggest one-day crash in stock market history, 1997 was a solid up year, and 2007 was an important top just before the 2008 sell-off. What will 2017 be?

The U.S. presidential election pattern reviews the four years after an election. In general, the U.S. stock market has been weak during the first two years after the election, strong the last two.

These 100-year statistics are not useful in predicting the trend of the market at any given time, but they are very useful in helping investors maintain a healthy, cautious mind. With this healthy caution in mind, I urge you to develop a personal investment plan that involves both buying and selling—something that reflects the wisdom of the slogan, ‘buy low, sell high’.

Financial trends in 2017

Continuing to hold our mind of caution, let us now review the current financial trends as 2017 begins.

■ Stock market: December of 2016 saw the S&P500 touch a new all-time high, for a gain of about 15 per cent for the year. As positive as this seems, the S&P500 is only up six per cent from its previous high in 2015. The TSX Composite was up about 18 per cent new year to new year. But on the longer term, the Canadian stock market has not yet exceeded its 2014 high. Realistically, in hindsight, we observed a strong uptrend in both Canadian and U.S. stock markets from 2009 to 2014-15, followed by a trendless sideways period. We interpret these observations as a bull market followed by a top, setting up the next bear market. That bear market will likely begin in 2017 and continue through 2018.

■ Long-term interest rates: Since the European financial crisis of 2011, U.S. long-term interest rates have fluctuated sideways, sometimes slightly up, sometimes slightly down. The overall bias has been slightly down. Canadian long-term interest rates have been in a more pronounced down trend since the financial crisis of 2009. Since the U.S. election eight weeks ago, both Canadian and U.S. rates have popped up. Central banks are doing what they can to maintain low interest rates. Normally prolonged low rates lead to high inflation.

So far, the only economic sector to exhibit high inflation is real estate. Thankfully, the Canadian central bank is using lending restrictions rather than raising interest rates to control speculation in Canadian house prices. Their fear is that higher rates will crush our delicate economic recovery. The important unknown is this: Was the July 2016 low in 20-yr+ interest rates the bottom, and is the six-month surge since then the beginning of a longer-term up trend? We will keep you posted.

■ Currency: The U.S. dollar has soared to new highs against the basket of non-US currencies. The last time the U.S. dollar was this high was January 2003! But, as newsworthy as that seems, the dollar has been going mostly sideways for the past 15 months. The post-Trump election surge in the U.S. dollar has changed its boring sideways drift into New Year’s news. The Canadian dollar has been in a downtrend vs. the U.S. dollar since 2011, when the natural resources boom ended. The loonie’s long-term trend remains down.

■ Gold: The recent surge in the U.S. dollar has been accompanied by a short-term downtrend in gold. In spite of this, the longer-term uptrend of gold that began 13 months ago is still intact.

■ Energy prices: Oil prices dropped into a dramatic downtrend that ended last winter, 11 months ago. That downtrend left the Canadian oil industry in shambles and the Canadian economy teetering. The price then bounced up, stabilized, and then eased up into a slight new recovery high in December. We have been waiting for a new decline in oil prices. If that hypothetical decline were to hold above the February 2016 low, it would indicate that oil’s downtrend had ended. But what if my assumption is too conservative? Maybe oil’s uptrend has already begun. How will we know? A bullish scenario would see oil prices rise above $60 a barrel, then decline to their current level (about $54)—then start up again.

So far, oil prices are trendless, in spite of OPEC’s chatter about lower production quotas.

Recommended positioning for the New Year

Conservative long-term investors are advised to hold lower than normal stocks and bonds, higher than normal cash reserves. We also recommend higher than normal exposure to alternative investments such as gold, gold coins and/or precious metals mutual funds.

Review of the Counter-Cyclical Model: the normal sequence for a stock market top is this:

1. Interest rates bottom. (The long-term bond market peaks.)
2. About six months later, more or less, the stock market starts to go down.
3. A few months later, the economy turns weak.

As 2016 ends, we see that the high in bond prices (read: the low in long-term interest rates) occurred six months ago, in July 2016. It is possible that the first element in the above sequence has occurred.

The U.S. stock market hit a new high in December 2016. If it peaks early in 2017 and starts a serious decline, we will become concerned that the second element is unfolding.

The economy is the third element in the sequence and it is the fly in the ointment. Since the 2009 recession, the Canadian and U.S. economies never really became strong. And the 2015 jolt of sharply lower oil prices crippled the energy sector. U.S. corporate earnings peaked two years ago. The economies are not in recession, but they are weaker than normal. This weakness has caused the Bank of Canada and the U.S. Federal Reserve Board to stimulate the economies more than they would normally. But the two economies (except for the housing sector) remain weak.

For this reason, stock-market risk is higher than normal as 2017 begins.

 

This is an edited version of an article that was originally published for subscribers in the January 2017/First Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.

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