It is reported that a young man once asked investment banker J.P. Morgan to predict what would happen to the stock market in the coming year.
“I believe the market is going to fluctuate.”
Based on recent stock market performance that assessment seems to be correct.
The American public generally measures stock market performance by looking at one of the indicators such as the Dow Jones Industrial Average. When President Trump won the election in November 2016, the Dow was around 18,000. By January 2018, the Dow reached over 26,000.
Is the stock market tanking?
Since reaching the high of more than 26,000, the Dow has plunged more than 7.5%. Let’s look at what caused the decline and what is likely to happen for the rest of 2018.
There were many factors that contributed to the sharp decline. One factor is that with the 40% increase in value since Trump’s victory, some investors simply wanted to sell stocks to realize the gain. Since the treatment of capital gains is more favorable this year, because of the new tax law, some investors waited until this year to sell and take profits.
This profit taking is normal after a large increase in stock prices. Experts say that corrections usually occur after large market gains. A correction means the market drops 10%. This time the correction was smaller.
At the same time, a new Federal Reserve (FED) chairperson was sworn in. This adds some uncertainty which always makes investors nervous. It is likely that the FED, which raised interest rates three times last year, will raise rates three times this year too. As interest rates rise, some investors will be induced to sell their stocks and invest in the bond market.
Interest rates could rise faster if inflation increases. There are signs that as the economy continues to grow, prices could rise faster, putting pressure on the FED to be even more aggressive with interest rates.
Lastly, the political environment is such that investors are very nervous. The Democrats talk about impeaching the president while the Republicans speak of improper and perhaps illegal actions taken by the Dems to obtain court-ordered search warrants. These actions also make investors nervous.
The Stock market will not tank!
There are many factors that influence the price an investor is willing to pay for a share of stock. Since a stock is a financial instrument, investors will pay a price based on the anticipated return. The expectation of a return is based on a number of factors, but the primary factor is the earnings of the corporation.
There are three reasons to explain why stocks have increased in value since Trump’s victory. One is that Trump has removed hundreds of regulations that have stifled economic growth. Since he did that, the economy has grown at a 3% rate. The average growth rate for the past eleven years has been just over 2%.
The other two reasons have to do with the tax cut. By increasing the disposable income (take-home pay) of about 80% of Americans, consumption will increase which will push economic growth even higher than the 3%. The Federal Reserve Bank in Atlanta forecasts that the economy will grow at a 5.4% rate in the first quarter of this year. That translates into higher corporate profits which will drive up stock prices.
The tax law also cut corporate tax rates from an average of 35% to 21%. Not only does that increase corporate net profit which will push stock prices higher, but it creates new capital for the corporations to invest and expand. So far, many major corporations have announced increased compensation for employees as well as announcing new large investments in the US.
The tax law makes it easier for US companies that earn profit outside of the US, to bring the money back to the US to invest. This too will increase economic growth and corporate profits.
Now is the time to enter the stock market
It appears that the market correction is over. Even though the market rise was unprecedented, the correction was just about 7.5% of market value, which is a relatively small correction.
As corporations announce earnings, which will beat expectations, stock prices will rise. As the economic growth accelerates, corporate profits will rise and so will stock prices.
The stock market will rise this year, probably hitting record levels. Since stock prices are relatively low today, this may be a good time to buy.
At any rate, it is true, “I believe the market is going to fluctuate.”