How long can this nirvana last for investors?
The stock market keeps methodically ticking into record territory, and the Dow Jones industrial average is trading above 23,000 for the first time. It’s been nearly 16 months since S&P 500 index funds had a pullback of even 5 percent over the course of days or weeks, its longest such streak in two decades.
Many analysts expect the market to keep climbing, at least for the next year. The global economy is improving, corporate profits are rising and inflation remains low but not so low that it makes economists nervous.
But as investors learned so painfully 30 years ago in October, markets can shift quickly. On Oct. 19, 1987, the S&P 500 plummeted 20.5 percent to wipe out what had been sizeable gains for the year.
Virtually no one is predicting a repeat of “Black Monday,” which was the stock market’s worst day in history and happened when conditions were different from today. But several worries are circulating underneath the market’s placid surface. While they may not cause a 20 percent drop in one day, they could be the spark for the market’s next drop of 5 percent or more, whenever it ends up happening.
Here are a few potential stumbling blocks for a stock market that’s more than tripled since its 2009 bottom in the Great Recession, including a surge of 20 percent over the last 12 months:
— Stocks are expensive. Even the most optimistic analysts wouldn’t call the market cheap. Stock prices tend to follow the trend of corporate profits over the long term, but stocks have been rising more quickly than earnings recently. The S&P 500 is trading at 31 times its average earnings over the last ten years, after adjusting for inflation, according to data compiled by Yale economist Robert Shiller. That’s the highest level since the summer of 2001, when the dot-com bubble was deflating.
By themselves, stock prices rising faster than earnings aren’t enough to cause markets to buckle. The stock market stayed at or above this level of price-to-earnings for years following the summer of 1997. But they’re enough to give some strategists pause.
— The Fed is tightening. The Federal Reserve slashed short-term interest rates to near zero in response to the 2008 financial crisis. It also took the unprecedented step of purchasing trillions of dollars of bonds to keep rates low. Those low rates meant bonds were paying little in interest, and investors moved into stocks in search of greater returns.
Now the Fed is slowly pulling back. This month it started paring back its $4.5 trillion in bond investments. And many investors expect the central bank to raise short-term interest rates at its meeting in December, which would be the third increase this year.
Higher interest rates make borrowing more expensive for companies, and those bigger interest payments could erode profits, at least modestly. Some investors are even talking about the slim possibility that the Fed will raise rates more quickly than it anticipates, if inflation picks up from its current slow pace. “Our downside scenario is that inflation becomes too hot and central banks wake up to the fact that they’re behind the curve,” said Jon Adams, senior investment strategist at BMO Global Asset Management.
— The leadership of the Fed may soon change. Janet Yellen’s term as chair of the central bank expires in February, and whoever sits in the seat next will have great influence over how quickly the Fed moves. President Donald Trump said he’ll likely choose from a field of five candidates, one of whom is Yellen.
Many analysts and investors expect the next chair to stick to the Fed’s announced schedule for bond-investment reductions, but any uncertainty could unnerve investors.
— Tax reform may fail, or the dollar may jump in value. Stocks have recently received a boost from rising expectations Washington will be able to cut tax rates. Lower taxes could mean bigger profits for companies and likely launch another round of stock repurchases by businesses. But if Washington stumbles, the disappointment could drag down stocks.
Strategists at Goldman Sachs say the S&P 500 may end the year at 2,650 if tax reform passes, which would be a roughly 3.5 percent gain from Tuesday’s close. But if reform doesn’t happen by then, the index may end the year at 2,400, down 6.2 percent from Tuesday’s close of 2,559.36.
If the dollar jumps in value, meanwhile, it would cut into the profits that multinationals have been making from their overseas sales.
— North Korea and other hotspots around the world remain big unknowns. Analysts call this “geopolitical risk,” and one of the reasons it’s so scary for investors is that it’s not possible to predict.
“There are a lot of dangerous things going on,” said John Vail, chief global strategist at Nikko Asset Management. Besides the worsening war of words between North Korea and the United States, he listed Ukraine and Syria as other areas with the capability of drawing the world’s big powers into conflict.
So far, investors have shrugged off such worries, but for how much longer?