Is Economic Growth Too Strong for This Market?

 | Feb 13, 2018 | 8:05 AM EST
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"Inflation is like toothpaste. Once it's out, you can hardly get it back in again."

-- Karl Otto Pohl

We have another bout of volatility this morning as interest-rate fears take center stage. Goldman Sachs predicted that 10-year Treasury notes could see yields rise to 3.5% in the next six months as the Fed continues its tightening cycle.

An increase in rates was what helped to trigger the collapse in the short-volatility trade and now the reverberations continue to be felt. This isn't a process that can be quickly priced into the market, which is why volatility is likely to stay at elevated levels for a while.

The reasons for pressure on rates is easy to see. We have the substantial cuts in business tax rates which is increasing economic growth, business optimism at record levels, a ballooning federal deficit as the Republicans turn into big spenders and some upward pressure on wages for the first time in many years. It is a recipe for higher rates and that is what is happening.

While higher rates are a major headwind, the big positive is that many stocks are seeing robust growth and the corrective action is creating some excellent values for the first time this year. Many stocks are still being jerked around due to the unwinding programs and the big computerized trading but eventually select stock-picking should emerge.

The major challenge right now is navigating the top-down swings that are being created by higher rates and the unwinding of the short-volatility trade while trying to find individual stocks that offer good values. Many of the charts are broken and certain sectors such as semiconductors are acting like death but valuations are attractive. The dilemma is that charts are trumping valuations and that is always the more important factor.

The bears have long anticipated that an increase in rates would be what killed this market uptrend. We have had a few minor scares since the days of the Great Recession but nothing that mattered for long. This time the rate fears have the backing of a strong economy and more aggressive government spending. Small business optimism is at all-time highs. The demand for capital is building and that is causing pressure on rates.

What can save this market is that the economy may not be quite as strong as portrayed. There are some signs that growth isn't at the levels projected and that may help to cool off inflationary pressure. Rates and inflation are still far below "normal" levels so maybe it isn't as good as feared.

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