Investors appear overjoyed with the state of the stock markets early in 2017. The euphoria could be heard in the cheers that greeted the Dow Jones Industrial Average crossing the 20,000 milestone in January, and the rally has continued into February.
Many market watchers are calling this the “Trump rally.” U.S. stocks are up around 7% since Donald Trump’s Election Day victory. This run has extended the current bull market to be one of the longest in the history of the U.S. financial markets.
But for all of the exuberance that’s accompanying this rally, stock investors shouldn’t be complacent about the current risks in the market. Here are some of the biggest analysts note at the moment:
An (Overdue?) Stock Market Correction
Almost invariably, bull market runs have periodic hiccups, causing drops of 5% to 10%. According to InvesTech Research, stock market corrections of at least 5% have occurred every 7 months during past bull markets, going back to 1932.
But as of mid-February, at least, U.S. stocks have gone almost an entire year without a drop in value of even 5%. Also, at its recent levels, the stock market is overvalued by many measures. For example, the current price/earnings ratio of the S&P 500 Index sits around 25, much higher than its historical average of around 17.
Given the Trump bump, then, your portfolio may have tilted too strongly in value towards stocks, which may leave you exposed in the event of a sudden market correction.
How can you minimize this risk? Begin by checking how much of your portfolio is allocated to stocks versus other asset classes such as bonds and cash holdings. If your stock allocation is too high for your risk tolerance, consider rebalancing your portfolio.
Not Responding Right to the Rally
The rising tide of the recent stock market rally hasn’t lifted all boats, or at least hasn’t lifted them all equally. Some areas of the equity market have performed better than others. For example, since Trump’s victory, stocks of smaller companies have outpaced those of larger firms. For example, the small-cap Russell 2000 Index gained over 13% from Election Day to the Inauguration.
Certain industries have also done better than others in the Trump rally. Stocks of financial, industrial and basic materials companies have soared over the last three months. Conversely, consumer goods, utilities and real estate have lagged the overall market during this time.
Your portfolio may reflect these differences in performance among asset classes and industries. At elevated values, these holdings may be prime targets for profit-taking in a market sell-off. You may consider selling some of these positions and locking in any gains, if it makes sense from a tax perspective and with your overall financial plan.
Potential Policy and Regulation Changes
Unlike Las Vegas, what happens in Washington D.C. never stays there. Changes to laws, regulations and public policies can impact you in many ways, including your investment portfolio.
As one example, the likelihood of Federal Reserve rate hikes in 2017 will have a wide-ranging ripple effect on the economy. When the Fed raises its target rate for banks, other interest rates climb higher too.
Higher rates increase borrowing costs for business and the interest rates consumers pay on their credit cards. Those higher costs can work against a growing economy and make stock markets nervous about the prospects for future returns.
But more importantly, when interest rates move higher, the value of bond investments head in the other direction. Declines are typically more severe in longer-term bonds. To manage the risks of rising interest rates, investors often shift their fixed income allocations toward shorter-term bonds.
Another risk facing investors from Washington is the uncertainty around legislative and regulatory changes from the Trump administration. Donald Trump ran his presidential campaign on a promise to shake up the status quo, and his early actions show he’s willing to live up to that promise.
But the arrival of this political outsider to the highest office in the country has come with mixed messages and contradictory statements from Trump himself, his cabinet nominees and the GOP establishment who lead both houses of Congress.
These contradictions make it difficult for investors to know what kind of economic reforms to expect or how to plan for their financial future.
For example, Trump and a senior economic adviser on his team recently criticized the high value of the U.S. dollar relative to other currencies. Strong performance for the dollar makes U.S. exporting companies less competitive in international markets
While Trump tries to talk down the value of the dollar, his nominee for Treasury Secretary, Steven Mnuchin, came out in favor of a “strong dollar policy” in statements he made during Senate committee hearings.
These differing views on the U.S. dollar are important because many of the economic reform proposals being discussed in Washington (e.g., the border adjustment tax) will have a significant impact on the dollar’s value, and therefore a direct influence on corporate profits and the financial markets.
Mixed messages from different administration officials leads to greater uncertainty in the markets and increased risks for investors. The financial markets will likely remain apprehensive until they see what becomes of Trump’s rhetoric.
To counter the market’s current state of fickleness, tune out the noise coming from the media (and Trump’s own Twitter account, too.) Wait to see the actual outcome of the political wrangling over the President’s agenda before making any decisions with your portfolio.