After a stalemate 1st quarter the Atlanta Falcons stormed to a dominant 21-3 lead over the New England Patriots going into halftime of Super Bowl LI. The Falcons were steamrolling ahead. They were winning the line of scrimmage battle on offense and defense and eventually took a 28-3 lead in the 3rd quarter. However as the game progressed, the Falcons appeared to wear down. A combination of: running out of gas, inflated sentiment and expectations, and poor decision making would eventually derail the Falcons and lead to the Patriots scoring 28 unanswered points to win the Super Bowl 34-28. It was the biggest comeback or collapse in Super Bowl history.

The Falcons’ regular and post-season run resembled that of an unloved bull market. Initially in the season most pundits and fans were pessimistic about the Falcons saying “didn’t they start 6-0 last year and miss the playoffs?” Later the sentiment around the Falcons transitioned into skepticism, “there offense is good, but you can’t win with that defense, and they can’t get it done when it counts.” All the while the Falcons were rolling ahead stacking up win after win. Finally things moved to optimism going into the Super Bowl and by the end of the first quarter. Somewhere between 21-3 and 28-3 everyone was buying the Falcons’ stock. Falcons’ owner Arthur Blank was seen celebrating on the field and the game wasn’t even in the fourth quarter yet. It was right at that peak of euphoric bandwagon sentiment that the Falcons ran out of steam and the bottom fell out.

Stocks tend to have a very strong final push at the tail end of bull market runs. They are pushed to new highs by overly optimistic sentiment until the expectations simply can’t keep up with the economic reality and like the Falcons the bull market eventually runs out of steam.

I am not predicting that we are about to head into a bear market by any means, but as investors we should always be assessing the markets defining where we believe to currently be in the market cycle, positioning the portfolio and visualizing possible scenarios. After the US presidential election it is clear that optimism in the markets is on an uptick. Typically the biggest gains in bull markets come in the beginning portion and the ending portion of the cycle. Remember the 1990s bull run and those final couple of years and their massive returns. Keep in mind that late stage push of a bull market can and has run for several years.

I see there being two major stories or themes in 2017 regarding the markets.

Volatility

• 2016 saw the first full correction in markets in several years, and two mini/almost corrections following the US presidential election and following the Brexit vote. We also saw capital markets make sharp moves based on headlines backed by little or no substance, specifically Donald Trump tweets.

• When stocks make sharp & fast gains to the upside, they tend to be more susceptible to sharp downside corrections. These all-time highs are likely to be accompanied by corrections along the way. Get ready for increased volatility.

• It is important to note, that corrections within bull markets are perfectly normal and help extend the life of the bull market. We must distinguish between corrections and bear markets as investors.

• Last week’s +1% push in markets in a day, was a perfect example of this increased volatility. Keep in mind volatility can be to the upside and to the downside.

How does reality match expectations?

• Markets have been rolling higher and higher since the election. There is an expectation that the new administration will reduce business regulations, reform corporate taxes, and enact a stimulus package. How will markets react when these things don’t play out as expected or don’t lead to the expected results?

• The Trump administration has been big on statements, but there has been very little specifics or action. If the new “phenomenal” tax plan isn’t so phenomenal, and the stimulus package proves to be a dud markets will be tested.

• I predict that there will be multiple setbacks to the administrations “pro-growth, pro-business” plans, and that markets will likely overreact to the point of correction. Sometimes it is wise to  “under-promise and over-deliver,” right now promises are high and it will be difficult to meet those expectations in the short-term.

Over the long-term capital markets are influenced by economics above all other drivers. We as investors can reasonably assume that the global economy will continue to expand and advance much as it has over the last 100 years; and therefore we will continue to reach new all-time highs in capital markets over the long-term.

Over the shorter term new information, and the relationship between expectations and reality in terms of economics, politics, and sentiment will move markets.

Economics

• The consensus expectation for 2017 economic growth is hovering around “more of the same” to “slightly accelerated.” Overall, global recession looks unlikely without outside/unforeseen contributing forces as the cause. Potential areas of concern include geopolitical upheaval and political/economic protectionism from populist movements. Left to the status quo, the global economy should expand in 2017 and potentially at a pace above the norm for the economic expansion of the last 8 years.

• After reviewing forecasts from JP Morgan, Goldman Sachs, and Wells Fargo Advisors, I expect global GDP growth around +3.5% in 2017, US growth of +2-3%, with potential for 2-3 Fed rate hikes, Europe +1.5%, Japan +1-2%, China +6%, and the UK with +1.5%. The growth expectations aren’t anything to dance in the streets about, but they are perfectly sufficient for stocks to continue the bull market run.

• I see two areas of concern: a stall in earnings growth, and Chinese upheaval. In the short-term markets will jump up or down based on the gap between expectation and reality, and if realty proves to be not so “phenomenal” it could push stocks sharply down fast. The key there is that a short and sharp correction is the more likely result than a prolonged steady decline bear market. The other area of concern is China. China has major structural concerns within it’s economy and it is very reasonable that it will show its ugly head again in 2017 like Q1 of 2016. At the end of the day, Chinese fears are likely to prove much the same way as last year…. short-term overreaction followed by the realization that China does not pose a contagion threat to the health of the global economy.

Politics

• US elections may be over, but there are major elections due up in Germany, France and the Netherlands in 2017. These elections are sources of opportunity in Europe, but also major risks. A changing of the guard in these major European countries will add uncertainty and volatility in the Euro markets. Last year we got the Brexit vote and the Trump victory, it will be interesting to see if populism movements continue to dominate world politics in 2017. For all of the perceived dangers that the regime change in the US has, the same fears and possibilities are there in these major European countries. We will be keeping a close eye on these elections.

• On March 15th 150 representatives will be elected to the Netherlands House of Representatives. The first round of the French presidential elections is on April 23rd. German federal elections will occur on September 24th. Investors should be monitoring the outcomes and potential implications of these elections.

• Protectionism is bad for everyone. Populist movements are being accompanied by very dangerous protectionist economic ideas. While I think that disastrous trade policy will be stopped by Congress in the US, the danger of it being enacted in France, Germany, or the Netherlands is still very real.

• In the USA there is an expectation of some tax cuts and/or reforms that will lead to an immediate increase in EPS among corporations. There is also and expectation that there will be deregulation and a possible stimulus package. For a time the expectations will be enough to move markets higher, but eventually there will need to be action and results to keep the party going strong.

• Corporate tax reform, and deregulation sound great, however an economic stimulus package has disappointment written all over it. The Keysian theory is that to boost or jumpstart the economy the federal government will temporarily increase spending on “projects.” It is an ingenious theory, but as we stand today the evidence suggests that it doesn’t work. It didn’t work under FDR, it didn’t work under Clinton, Busch or Obama. In fact the recent history of federal stimulus packages is a run up in expectations, followed by a disappointing temporary uptick in economic numbers, followed by small recession after the stimulus money has ended. Federal stimulus packages are kind of like when you went to see Indiana Jones and the Crystal Skull. You were so excited that Indy was back, you watched the originals again, all this expectation only to be super disappointed with the result. You were so disappointed that you needed time to recover and forget that you had ever gotten excited about such a terrible movie.

Sentiment

• Gauging sentiment in the markets is not an exact science, but it is imperative that we look at the indicators we have. We are able to track things like mutual/index fund inflows to see how many investors are moving into stocks and compare that with historical figures. We can compare prices/earnings and other stock valuations with historical data. We can track the number of bullish/bearish articles being published, and the number of IPOs being brought to market. We can track how many of those IPOs are companies that do not actually turn a profit, yet are being bought up by investors. We can monitor the amount of hedging being done in the markets, and last but not least we can talk to people make assumptions based on our discussions. After we have done all of these things we can make a general assumption as to the sentiment level of the markets.

• Right now, I feel pretty comfortable in saying that sentiment in the markets is improved and potentially continuing to improve. Many like to say that “the animal spirits have been awaken” and that is a good analogy. Enthusiasm can be contagious and it certainly looks like that has started to be the case. We as investors need to be watching and monitoring that optimism and enthusiasm doesn’t transform into irrational exuberance.

Risks

• Trade Protectionism: Whether it is in the USA or abroad there has been momentum behind protectionist policies. Nothing is more dangerous to the overall health of the economy than the implementation of such polices. When participants take part in trade, the buying and selling of goods/services via their own volition it is positive for all parties. There zero sum economic theory is false, and dangerous.Tariffs are a tax on consumers, raising the price of goods and increasing inflation. They also invite retaliation by foreign countries.

• Erratic Politics: President Trump has been erratic thus far in his term. His behavior has been a major contributor to the sharp movements we have seen in capital markets in 2017. If his erratic behavior continues it could eventually be a drag on the markets. Capital markets, generally respond well to predictability and boringness.

• Geopolitics: Conflicts abroad are always a threat to capital markets and economic expansion. Many times I have heard the false narrative that “wars are good for the economy, think WWII.” Without going into a full lesson in history and economics, I will simply say that “war and geopolitical conflicts are not good for the economy.” War typically does create an environment of winners and losers where certain industries and individual companies benefit mightily from the conflict. We should not confuse those specific and anecdotal results for being an overall boost in economics. Specific theaters of risk right now include but are not limited to: North Korea, Eastern Europe/Russian, and of course the Middle East.

• Political Letdown: Right now there is a lot of hope built into the market. It is impossible how much exactly, but it is fair to say that there is optimism for coming tax reform, deregulation, and a stimulus package in the US. How far do capital markets run, and how far do they pullback when things don’t pan out quite so nice?

Conclusion

Continued global economic growth, a potentially favorable political environment, and increased optimism bodes well for capital markets in the coming months. Erratic political behavior in the US, and the potential for a “changing of the guard” in major European countries will likely contribute to increased volatility beyond what was seen in 2016. Lastly, the improving sentiment in the markets could potentially overheat. However, increased volatility could slow gains enough to extend the term of this final leg of the bull market. Remember how long markets soared in the late 90s on positive sentiment, before anyone realized that cats.com didn’t make any money and the emperor had no clothes.

 – Wyatt Swartz

3/9/2017