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3 reasons to treat Dow 21,000 with caution

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Latest MoneyWatch headlines 01:08

U.S. equities suffered their largest one-day loss since January on Thursday, in a dramatic attitude shift after Wednesday’s massive “meltup” that pushed the Dow Jones industrials index over the 21,000 level for the first time. That jump was at least in part due to apparent excitement over President Donald Trump’s more moderate tone in his address to Congress on Tuesday night.

But less than 24 hours later, investor sentiment was chilled by more “Russian influence” headlines for the Trump White House and increasingly hawkish commentary from the Federal Reserve ahead of a speech by Chair Janet Yellen on Friday.

Other headwinds include a rapid marking down of first-quarter GDP growth expectations, tepid earnings growth and very extended sentiment measures. Investors would do well to use this opportunity to cautiously consider trimming their exposure, rebalancing out of relatively expensive stocks.

Trump's speech to Congress 02:44

Instead, mom-and-pop investors seem to be doing the exact opposite: A recent report by JPMorgan shows retail investors have poured more than $80 billion into “passive” index funds while institutional investors are backing away.

Here are three good reasons to be nervous.

First, the Fed is suddenly making very hawkish noises heading into the March policy meeting in less than two weeks. Futures market odds of another quarter-point hike have pushed above 90 percent, well more than the threshold that triggered rate hikes in December 2015 and December 2016. 

Consider this collection of comments this week sharing a common theme that more rate hikes are needed soon:

  • New York Fed President William Dudley said the case for tightening had become a lot more compelling.
  • San Francisco Fed President John Williams said he expects a rate hike to receive a “serious consideration” at the March policy meeting.
  • Fed Governor Lael Brainard, one of the most dovish Fed policymakers, said continued removal of policy accommodation was likely to be appropriate soon. She cited positive momentum in incoming data, evidence of a labor market near full employment and rising inflation pressures.
  • And Fed Governor Jerome Powell told CNBC that the case for a March rate hike had “come together,” while reiterating his expectations for three rate hikes in 2017.

A more aggressive pace of rate hikes is a huge change in the monetary policy stance that, frankly, isn’t getting the attention it deserves. Consider that the Fed has raised interest rates only twice in the last 10 years, but it’s poised to accelerate that to two hikes in just three months.

Trump rally 01:39

Second, GDP growth expectations are actually moving lower, in sharp contrast to the post-election triumphalism about deregulation, tax cuts and more stimulus from Mr. Trump. The Atlanta Fed’s GDPNow real-time estimate of first-quarter growth has fallen to just 1.7 percent. 

As for earnings, while analysts are looking for S&P 500 profits to grow 9.8 percent in 2017, an aggressive market rally has pushed the forward 12-month price-to-earnings ratio to 17.9 vs. a 10-year average of 14.4.

Third, turning back to Mr. Trump, Wall Street is cooling to hopes that proposed tax cuts and other reforms will be forthcoming. Goldman Sachs has warned taxes are increasingly a story for 2018, not 2017. 

UBS strategist Yianos Kontopoulos, in a recent note to clients, warned amid rising complacency that “the market is learning that new U.S. policy initiatives may also be slower to come.” While he doesn’t believe this could necessarily lead to a sell-off, he thinks the “upside in stocks may be moderate” and investors should consider adding some long-term bond holdings to rebalance their risk profile.

Wells Fargo strategist Paul Christopher noted that while the president’s “sweeping and conciliatory” speech was well received on Tuesday, a lack of clear policy guidance from the White House means “Congress may struggle with divisions over crucial decisions.” Witness internal stifle within the GOP over plans to reform health care.

Amid tepid economic growth and policy tightening from the Fed, investors may realize their enthusiasm went a little too far as Mr. Trump’s economic initiatives get bogged down by typical Washington gridlock.  

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