Jim Stack: A Cautious Bull

04/06/2017 2:50 am EST

Focus: STRATEGIES

James Stack

President, Stack Financial Management

This month, the economic recovery becomes the third longest in U.S. history! At 7.8 years of age, this recovery is over twice as long as the historic average, and surpassed only by the decades of the 1960s and 1990s, observes market historian and money manager James Stack, editor of InvesTech Research.

We call it mature because consumer confidence is near a 16-year high, the labor market is becoming very tight, and inflation pressures are rising.

This is when the skies appear blue, there are no obvious economic clouds on the horizon, and when investors need to be most careful.

While this steady outlook clearly shows that the Federal Reserve expects to implement a slow, steady (and modest) climb in interest rates over the next couple years, emerging evidence points to a more dynamic scenario.

The state of the U.S. job market is among the more important factors that drive FOMC interest rate decisions. Unemployment claims are a key leading indicator for the employment outlook and are at the lowest level since 1973 – near the start of the last major inflationary period.

Underneath the surface, inflation pressures are starting to build.The Institute for Supply Management Survey of prices paid in the manufacturing sector is sitting near a level not seen since May 2011.

Ned Davis Research monitors 22 indicators which are included in its Inflation Timing Model. Over the past year, this model has been moving up sharply.

At the same time, the Future Inflation Gauge from the Economic Cycle Research Institute is hovering near a post-recession high. If these trends continue, inflation will become a much bigger problem for the Fed.

Bottom line, a stronger than expected economy and entrenched inflation pressures typically lead to a more rapid increase in interest rates.

Historically, systematic tightening in monetary policy during a mature economic expansion has led to the onset of a recession. The U.S. discount rate moved steadily higher prior to every recession since 1960. As such, we are nearing the point in the economic recovery when “good news” might be bad news for investors.

There are disturbing signs of excesses, one of which is the lofty level of stock valuations on Wall Street. Today’s P/E ratio for the S&P 500 (26.6) ranks among the most expensive in history. The higher the valuation, the greater the downside risk in the next bear market.

Signs of excess speculation and enthusiasm are a major concern in an aging bull market. The reason most investors get trapped near bull market tops is because there are no obvious warning flags. No bell is “rung” at the top.

In virtually every case, economists are universal in their “no recession” forecasts. And both confidence and complacency are often at very high levels. In fact, by definition: “A bull market peaks when investor confidence is at its maximum level.”

With pressures building on the Federal Reserve and the potential for upside surprises in interest rates, we believe that today could be a similar situation and are carefully watching for a market top in 2017. For now, we are comfortable with our invested portfolio allocation of 84% and a 16% cash reserve.

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