Market Review for 4th Quarter 2016
While the market’s gain was generated entirely after the November elections, there were other factors that helped drive the market higher. In the fourth quarter, markets appeared to be buoyed by an improved outlook for real GDP growth and rising corporate profits. Estimates for real economic growth for the near term were raised to over 3%; a significant improvement over real growth in the first part of 2016. Improved real growth is expected to continue through the first half of 2017.
The stock market’s rise has been helped by low interest rates at the short end of the yield curve, but that help may be ending. The Fed signaled that it will raise short-term rates over the next year, and began to do so shortly after the election. The Fed has indicated it might raise short-term rates as many as three times in the coming year. The Fed’s policy of raising rates is based on its belief that rising real growth produces inflation, and that the proper response to increasing real growth is to raise rates. The last 100 years of economic data have shown the Fed’s belief to be wrong; rising real growth does not lead to increasing inflation. Mistaken monetary policy produces inflation, but not rising real growth. The proper reaction to anticipated or experienced increases in inflation is to reduce the rate of increase in the money supply, not raise rates. There is only a loose connection between interest rates and the rate of growth of the money supply. If the Fed misapplies the tools it has on hand, the stock market and the economy will suffer; real growth will slow down and corporate profits will stagnate.
A new Administration will take office this January. Its economic policies are the subjects of much speculation. Currently, there is no way to determine what will unfold in real time. A watch and wait policy seems appropriate.
The economy and corporate profits are poised to grow at near or above average rates for the next six to twelve months. The primary obstacles to these favorable outcomes are mistaken policies on the part of the Fed or the new Administration. In these circumstances, it is likely that stocks that are fairly valued with visible earnings increases are likely to do well when compared to those relying on helpful changes in economic policies.