There’s been an opinion going around the investment world that the U.S. stock market is about to fall at least 5-10%. We agree with this assessment. There are very valid reasons why the S&P 500 might fall that much right now. However, the odds of this happening are not exceptionally high, which is why we have not sold any stocks.
Why the S&P might make a small correction
There are essentially 2 reasons: one fundamental and one technical.
It’s clear that Trump’s pro-growth policies are facing significant backlash in Congress. With nearly every Democrat against Trump, he needs to unite the Republican Party if he wants to pass anything. This is very difficult because on the political spectrum, the Republican party is extremely diverse. You have moderate Republicans who never believed in some of Trump’s policies in the first place, and then you have the far right Freedom Caucus who will block any policy that smells of “big government”.
The Obamacare repeal is important to the markets because it demonstrates exactly how much difficulty Trump will have in passing his policies (tax cuts and infrastructure spending). With Obamacare repeal on the verge of failing, it’s clear that Trump will have trouble passing anything (except maybe tax cuts, which has always been a central plank of the Republican Party).
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Thus, some bearish investors and fund managers believe that the S&P will fall on headlines such as “Trump is having trouble passing Trumpcare” or “Trump cannot get tax cuts through Congress”!
Yes, it’s true that much of the November 2016 – March 2017 rally was due to the market’s belief in Trump’s pro-growth policies. However, that belief did not account for the entire rally. Part of the rally was due to an improving U.S. economy and global economic recovery (China and Europe coming out of a multi-year slowdown).
From a technical standpoint, some traders think that VIX (volatility index) is too low. They believe that when something like VIX is compressed for too long, it will spike upwards. This means that market volatility will skyrocket and the S&P will fall significantly. (VIX and stocks have an inverse correlation).
Why these concerns aren’t really relevant
Regarding the fundamental concern (Trump’s difficulties with Congress), we addressed this yesterday. Trump-related news is not what impacts the S&P 500 in the medium-long run. In the medium-long run, the state of the economy drives the market.
The U.S. economy is growing nicely right now. There are no signs of a slowdown. In fact, U.S. economic growth has actually picked up since October 2016! (Ignore Q1 GDP forecasts. Q1 GDP has always been exceptionally weak over the past few years, probably due to seasonal factors).
In addition, any news of Trump-related difficulties will not cause the S&P to fall 15-20%+. Trump passing no pro-growth policies will not adversely impact stocks in a significant way. Any pro-growth policies that Trump does pass will merely be extra icing on the cake.
The technical concern (VIX needs to spike) is pure BS. As of this writing, VIX is rising rapidly even though the S&P has not fallen a lot! In addition, VIX is a very poor indicator. VIX typically hits all time lows (as it’s doing right now) long before the stock market tops. This happened in 2006, an entire year before the S&P topped in October 2007!
We focus on the medium-long term
We’d say that there’s a 60% chance that the U.S. stock market will correct 5-10%. The stock market has a natural bullish bias. This means that it goes up more than it goes down during a bull market (57% of days in the past 50 years have closed higher than the day before).
Thus, it is not wise to sell stocks until you’re 95% certain that either a bear market is coming or a big correction (e.g. 20%) is coming. Small corrections of 5-10% really are anyone’s guess and cannot be predicted with consistent accuracy.
*On a sidenote, we avoid all the bear markets and big corrections that we can. We leverage our positions by 3x, which means that if we sidestep a 20% correction, we avoid a 50%+ drawdown in our portfolio! Then when we buy at the bottom and the market rallies back to a new high, we more than double our money!
On a completely unrelated sidenote, I finally recovered from an illness and got back in the water. The surf has been pretty sloppy recently, but the sunset is nice.