Stocks in the S&P 500 face an uphill battle in 2017 with key drivers pointing lower. Is your portfolio ready for stocks to fall?
The stock market was up just 4% over the first ten months of last year after closing flat in 2015. Stocks surged after the election to end up more than 11% on the year.
Investor excitement for stocks and the economy has been reborn and nobody is talking about a stock market crash anymore. Underneath the anticipation for returns are some very real roadblocks, key drivers of the economy and the market that could cause stocks to fall in 2017.
I pointed to some of the risks and potential upside for stocks in last week’s post on the best investments for 2017. A lot of you wrote in that the risks I outlined were things that might or might not happen and didn’t really make the case for weak stock prices this year.
Make no mistake, the stock market’s direction this year isn’t a matter of whether a handful of things happen or not.
There are five fundamental forces that will work against stock prices, five factors that could overshadow all the deregulation and infrastructure spending on which investors are hoping.
As you read through the five hurdles that could trip up stocks this year, ask yourself if the average analyst’s 3.6% upside target on the S&P 500 is worth the risk of losing half your portfolio in another stock market crash.
I’ll cover the five reasons why stocks will fall in 2017 and then what you can do to protect your hard-earned money.
Stocks Prices are already Expensive
Stocks are expensive by just about any measure. The most common, price-to-earnings, is at 28.5 times on a cyclically-adjusted basis. That’s well above the average P/E of 20 times recorded over the last 50 years.
Anytime stocks get this expensive, you hear analysts use expected earnings to justify the higher prices. The idea is that companies are expected to grow profits by so much over the next year that today’s high prices will be worth owning a piece of a larger pie.
Wall Street is forecasting corporate profits to increase by 11.5% over the next year, impossibly high expectations given faster wage growth and increasing interest rates. This is despite the fact that earnings have barely budged over the last several years and only grew around 7% annually even in the economic boom heading into 2007.
Even assuming companies are able to manipulate financial statements for that 11.5% growth, it still only brings the P/E ratio down to about 27-times due to inflation and the way the average earnings are calculated.
Stocks will fall because investors will get tired of paying so much for promises of earnings growth that might not be there. Investor excitement is enough to support high stock prices for a little while but it only takes a few bad economic headlines to shake that excitement and cause the whole house of cards to fall.
Higher Interest Rates Could Drive Stocks Lower
Perhaps the biggest reason why stock prices will fall in 2017 will be that if Trump gets his tax reform and fiscal spending, he’ll have to fight the Federal Reserve for the fate of the economy.
The consensus at the Federal Reserve is for three interest rate hikes this year. That will mean higher borrowing costs and interest payments for consumers and businesses.
The Fed isn’t trying to drive us into a recession. Its job is to balance the risk of inflation against a healthy job market. People don’t like being unemployed but they also don’t like it when prices skyrocket…so these two forces must be managed.
With a fairly healthy economy and unemployment as low as it’s been since 2007, the Fed is turning its focus on making sure inflation doesn’t increase too much.
The table below of the Fed’s projections is a little busy but I’ve circled important numbers. The central bank is expecting economic growth of about 2.1% next year and that unemployment and inflation won’t change much from 2016. On this, they are expecting to raise interest rates nearly a full percentage point.
What happens if the economy picks up even more, unemployment falls and inflation heats up? The Fed would be forced to raise rates even faster to cool things off. Some officials already see rates going higher by 1.5% over the year.
One upside is that higher rates may increase returns on peer loans and other fixed income. Bond prices will fall if rates go up but you always get the fixed interest and maturity payment if you hold the debt investment to expiration. New bonds and p2p loans that are issued will be at higher rates as the Fed raises.
I’ll detail my own investing strategy later on but P2P investing through Lending Club is one of my favorite ways right now to earn a decent return while protecting myself from a stock market crash.
Low Unemployment Might be a Bad Thing for Stocks
People generally think of low unemployment as a good thing for the economy and for stocks. The problem is there are only so many workers available. Claims for unemployment dropped to a 43-year low recently. That means employers will need to start boosting wages to fill new jobs.
That’s fine for workers but it will make it impossible for corporations to meet the 11.5% earnings growth expected this year. Earnings fell for six-straight quarters to the third quarter of 2016 and much of the market’s enthusiasm is based on continued earnings growth.
So you’re thinking, “So what, higher wages is a good thing. Don’t we want extra money in peoples’ pockets?”
Higher wages are good and some of it will feed into higher consumer spending. The problem, besides the hit to earnings growth, is that it will push inflation higher and cause the Fed to raise rates faster.
The graphic below is of initial claims for unemployment with shaded areas indicating recessions…notice anything?
History suggests it takes about six months to a year and a half for higher rates to start weighing on the economy. The Fed raised rates for the first time this cycle in December 2015 but then kept them there for most of 2016. If they are serious about increasing rates this year, it might not be that long before higher borrowing costs start to cause economic projections and stocks to fall.
The Global Economy isn’t Strong Enough to Support Stock Prices
Even if President Trump can eke out decent economic growth here at home, the global economy is struggling. Global trade was up just 1.7% and the overall economy increased just 2.2% last year.
Putting America first is one thing but S&P 500 companies get nearly a third of their sales overseas.
Slow global growth is a problem for several reasons:
- Stronger U.S. growth will cause the dollar to strengthen against other currencies. This will mean U.S. exports are more expensive when they compete in other countries and could spell trouble for companies.
- Slower economic growth will mean people in other countries just won’t be buying as much, whether it’s U.S. products or those from their own industries.
- A stronger dollar also means that the sales booked internationally are worth less when cheaper currencies are converted to the greenback for financial statements.
This all means more trouble for corporate earnings.
Starting to see why I say it’s impossible that S&P 500 companies will hit 11.5% earnings growth this year?
Stock History is not Kind to Incoming Presidents
Listen to the pundits heading up to the election and you would have thought that a Trump presidency would mean certain doom for the stock market. The Donald’s off-the-cuff comments and outsider ideas had market analysts predicting a huge market selloff if the Republicans won the White House.
Now it seems the market loves a change. Stock prices have surged on the idea that the new administration will bring new ideas.
Stick around long enough and you see it every four years. Investors love to bid markets higher on hopes for a new administration…and then lose that hope quickly when reality sets in.
It’s worth noting that stocks only rebounded during President Obama’s first year because they had already fallen so far to March of that year.
Many of President Trump’s promised policies could be very supportive of the stock market. The problem is that it’s much faster to talk these policies up than it is to actually implement them.
- Corporations are balking at the idea that private money will pay for infrastructure spending. Infrastructure investment is expensive and only provides marginal returns over a very long period, an investment that’s not very attractive to companies.
- Lowering corporate taxes sounds good but will face an uphill battle in Congress. Democrats will want a trade for a higher minimum wage or spending on social programs, something that may not go over easily.
- Regulation is like a loose thread. You can’t just start pulling or the entire sweater will unravel. It’s going to take time to pick apart some of the regulatory burdens the President has targeted.
Once investors realize it may be a year or more before policies actually start helping the economy, they may lose interest and send stock prices tumbling.
Does it Matter if Stocks Fall in 2017?
Whether stocks fall in 2017 or not, you may not have to do anything if you’ve got more than 15 years left to retirement. I outlined why I don’t worry about a stock market crash in another post and what you can do to take the stress out of investing.
For those with less than a decade left to retirement or that haven’t rebalanced their investments in a couple of years, don’t sit there while the market is flashing red.
The last eight years have been uncharacteristically profitable for investors with the S&P 500 up more than 184% since March 2009. That’s only happened in four other occasions over the last 60 years (1961, 1987, 1990 and 2000).
The stock market pundits on TV have all the appearance of desperate gamblers, trying to rationalize just one more year of gains. I’ve seen it all before, investors trying to eke out one more year of returns despite everything else telling them to take the money and run.
I urge all investors to take another look at their investment accounts and retirement plans. Whether you are planning on doing anything with your stocks or even believe that the stock market will fall this year, ask yourself these questions:
- How much do I need to retire? How many years do I have until I want to retire?
- How much can I realistically put in my retirement or investing accounts over remaining working years?
These three questions are the most important an investor can ask but so often neglected. Having a realistic estimate for these three questions will tell you exactly how to invest your money, taking all the uncertainty out of the stock market game.
The point to all this is that, after eight years of a stock market boom, many investors need a lower annual return to meet their retirement goals. Does it make sense to stay fully invested in stocks, hoping for one more year of high returns and risking a big loss on your portfolio if stocks crash, if you could take some risk off the table now and still reach your retirement goals?
How to Invest in 2017 to Avoid Falling Stock Prices?
Asking myself the three questions above, I was surprised to find that I only needed an annual return of about 3% on my portfolio to reach my investing goals.
Knowing this, I’ve got two choices:
- Keep most of my money in stocks, adjust my investing goals higher and be like all the other investors that lose sleep when stocks fall and destroy their retirement dreams.
- Be grateful for the last eight years of returns, change my investments for less risk and then jump back into the stock market when the next crash hits.
Yeah, I’m picking the second option.
First, I’m rebalancing my money across asset classes. This means taking money out of stocks and putting it in safer investment types. I am putting more money in bonds and peer loans through Lending Club.
There are investors that will tell you peer loans are not as safe as stocks but that’s a misconception. I agree that peer lending isn’t as safe as investing in AAA-rated bonds but default rates in the highest two categories on Lending Club are under 4% with an adjusted return of 6%. That kind of risk is easily manageable and the return is many times over what you’ll find in bonds.
I’m also shuffling the money around in my Motif Investing account. I’m selling some of the stocks that have done well over the last year like CSX Corporation, up 87%, or Devon Energy (105%). Besides investing in some bond funds, I will also shift some of the money to safer sectors like healthcare and utilities and value plays like pharmaceuticals and agriculture stocks.
For some of the stocks I am keeping, I will reduce the downside risk by selling call options against the position. This is something I talked about in a previous article on how to use options investing without gambling. Selling call options gives someone else the right to buy the shares from you in the future for a payment today. You get to keep collecting dividends and only sell the shares if the price is above the call option strike price when the options expire. It’s a great way to reduce risk of a stock market crash but still have some upside opportunity.
The Sky is Falling for the Stock Market…or is it?
There are some upside factors that could support the stock market in 2017 which I pointed out in our annual outlook. The hope for fiscal spending and less regulation is just enough to give the optimists something to hold on to for higher prices.
The problem is that if stocks don’t fall this year then the odds are even greater in 2018. Business cycles don’t go on forever and the more the government thinks it can manage the economy, usually just means the deeper the recession we’ll get when it comes.
The point here isn’t to be afraid of a stock market crash but just not to get caught up in the greed for returns. The current bull market is the second-longest in history, that alone should tell you something. Understand that stocks are expensive right now and you have other investing options.
It’s your money. You can play the stock market game and risk what you’ve earned for a year or two (at most) of single-digit returns or you can protect your portfolio and wait for cheaper stocks when the market falls.
As for me, I’m protecting my money against a stock market crash in 2017. I’m shifting money to safer assets like bonds, peer loans and safety stocks. Wall Street can make all the excuses it wants for why stocks will rise this year but the five forces above are big drivers on the economy and the odds are for stocks to fall hard. Be ready!