Throughout 2017, there were two market sectors I couldn’t take my eyes off: bitcoin and the Dow Jones Industrial Average.
Where bitcoin goes from here following its spectacular price fall I’m not entirely sure.
Yet as the price of bitcoin drops, the Dow is surging higher.
The Dow was up 13% in 2016, rising from 17,425 to 19,672 points.
2017 was an even better year. The index broke records, making five new 1,000-point milestones in 11 months. This time last year, the Dow was trading at 19,804. By the end of 2017, the Dow finished at 24,719.
These record-breaking milestones meant that the Dow gained a whopping 24.8% over the course of 2017.
Now, three weeks into the new year, the Dow has already cracked two new 1,000-point milestones. The Dow broke through 25,000 on 4 January. A little over a week later, it closed above 26,000.
Given the power behind the Dow’s rally, there’s very little to stop it breaking through 27,000 and even 28,000 by April. And it could start knocking on the door of 30,000 points by November.
US President Donald Trump’s tax cuts are no doubt helping the rally. However, punters may be giving him too much credit for it.
In 2013, Larry Fink, CEO of BlackRock, boldly forecasted that the bull market had another five or six years to run. And that the Dow would be at more than 28,000 by 2019.
Fink said in May 2013 that corporate earnings were solid, but that stocks were undervalued. What’s interesting is that, when Fink made these comments, the Dow was around 15,300 points.
However, in my view, the Dow is useless when it comes to assessing the US economy.
There are more than 5,100 publicly traded companies on the New York Stock Exchange and NASDAQ. Of that number, only 30 of the largest US companies make it into the Dow index.
Furthermore, the Dow is what’s known as a price-weighted index. This means that each stock influences the index in proportion to its price per share.
Take Boeing Company [NYSE:BA] and Apple Inc. [NASDAQ:AAPL] as an example.
The share price for BA was US$352 overnight, compared to US$179 for Apple. Movements in Boeing’s share price have twice the impact on the Dow than Apple’s. Despite the fact that Apple is worth US$919 billion — four-and-a-half times Boeing’s US$209 billion market cap.
In other words, any news from Boeing will have more influence on the index than Apple.
To examine the US market, S&P Index is the key
Because of this, when it comes to analysing the US market, a far more useful measure is the S&P 500 index.
This index measures the performance of the top 500 companies in the US.
The S&P 500 is a ‘free float capitalisation weighted’ index. In other words, S&P 500 stocks are weighted based on the market value of their shares. That way, the impact from share price movements is proportional to the value in the S&P 500.
As a result, the S&P 500 trades at a much lower value, at around 2,802 points — although the S&P 500 still had an incredible 2017, rising 23%.
The problem is that an S&P 500 rise of 50 points in 10 days doesn’t sound as sexy as the Dow smashing through 26,000 points in the same timeframe.
With that in mind, what can we expect from US markets this year?
In my view, you can expect plenty of commentary on a potential market crash.
Massive leaps in stock and bond prices and other US assets have led to the coining of a new term — the everything bubble. Low interest rates in the US have meant that investors have pumped money into anything and everything in search of growth.
However, it may be another year or two before any major stock market correction comes our way.
On the positive side, the weak US dollar is good news for US companies. Businesses with large international operations report larger profits when international currencies are converted back into US dollars.
Meanwhile, economic data coming out of the US suggests the economy is robust. Gross domestic product for the third quarter was 3.2%, expanding at the fastest rate since 2015. Inflation in the US is running at 2.1%. And the unemployment rate sits at 4.1%.
Of course, long-time readers will know that there are issues with the methodology behind these statistics. But I’ll save debating their validity for another day.
Another big year ahead for US stocks
The point is, on paper, and with rubbery numbers, the US economy looks to be in good health.
And that’s before the effects of Trump’s tax reforms play out — even if it’s likely that the cuts have been priced into the markets already. Either way, the full effects will become clear as companies start paying significantly less tax than before, which should increase profits across the board.
Finally, the US Federal Reserve Bank’s actions will also have a bearing on the economy.
The expectation is that there will be two or three rate increases this year. Assuming inflation and employment remain close to what the Fed wants, investment bank UBS says the Fed is likely to start bumping up the cash rate as soon as March.
To date, the broader market has taken each rate rise as a positive sign. Remember, higher rates suggest a stronger economy.
Will future potential rate rises have the same effect? That remains to be seen. However, it could be another incredible year for US stocks.
For Money Morning