Dow Jones Forecast for 2018: "Dow 20,000" Caps Will Come Back in Vogue Lombardi Letter 2017-11-28 08:31:30 Dow Jones forecast for 2018Dow Jones predictions 2019Dow Jones predictions 2020Dow Jones year-end forecastkey indicators predicting DJIA forecastDow companiesDow stock listDow Jones Industrial Index A simple math calculation says that the Dow Jones Forecast for 2018 is up & could hit 20,0000. Analysis And Predictions 2018,News,Stock Market https://www.lombardiletter.com/wp-content/uploads/2017/11/dow-jones-forecast-2018-150x150.jpg

Dow Jones Forecast for 2018: “Dow 20,000” Caps Will Come Back in Vogue

dow jones forecast 2018

Credits: iStock.com/Skywalker_ll

Quantitative Tightening Effects Weigh Down Dow Jones Forecast for 2018

It’s tough being a stock market prognosticator these days. The traditional metrics used in the old paradigm don’t matter like they once did. Yet, the new paradigm metrics don’t make much sense on a valuation level, thus painting a confusing portrait for investors. I’ll attempt to make sense of it all with my new Dow Jones Industrial Average forecast for 2018.

As of this writing, the DJIA is trading at 23,444.62, an increase of around 10,435 points over the past five years (80.2%). It’s been an extraordinary run, considering that economic growth, as measured by national gross domestic product (GDP) levels, has meandered around the inflation rate.

Lately, the U.S. economy has “broken through” this point, registering growth in Q2 and Q3 2017 of around three percent. This has been bolstered by the cumulative effects of President Donald Trump’s pro-growth policies and domestic hurricane rebuilding efforts, but sustainability is in question. The boost delivered by the latter will not help the Dow Jones forecast for 2018.

So, if real organic economic growth is—for the most part—relatively benign, why the explosion in equity prices? Three words tell most of the story: central bank liquidity. Far from being simply an American phenomenon, money printing presses are running overtime on every continent on earth.

This is no accident. The world’s central banks are engaging in a multi-pronged effort to boost asset prices and consumer demand. The thinking is that low interest rates help keep debt ratios low, fostering more spending. It also helps promote stock market price expansion as investors reach for yield, thus contributing to the “wealth effect.” Both assumptions have proven to be true, to a large degree.

This all works fine if interest rates never rise. The great business expansion grinds on because low rates promote a constant trick of debt into the system, keeping demand steady. Thus, the economy never gets really hot, nor really cold. It just grinds upward in this low-growth, sloth-like morass.

Our algorithmic-fueled markets love this environment, because economic growth is just strong enough to keep the lemmings from sustained selling. Sustained selling is the only thing that can disrupt the current market paradigm. Markets will levitate up by default, on the backs of record investor inflows, stock buybacks, and return-chasing money managers. Volatility sellers have made a killing shorting volatility into any spike, in what has become the most predictable and profitable trading this millennia. Big Money knows who has their backs.

VolatilityLowestSince2007Beware_Chart

But could this investor unreality be ending? Nobody seems to believe it, despite the fact the Federal Reserve (and others) are telling us so.

Back in September 2017, the Fed announced it would not be reinvesting bonds up to set limits as they mature. The Fed hopes to drain $50.0 billion/month out of the system by next year, halting and reversing the quantitative easing (QE) effect which is responsible for the greatest bull market in history. Yet, somehow, investors could only muster a collective yawn. (Source: “After the Fed’s great unwind begins, the stock market yawns,” Financial Post, November 2, 2017.)

That is quite surprising, because the move also eliminates the biggest buyer out of the bond market. The net effect, of course, should pressure interest rates higher.

That creates a potential double-whammy conundrum for the market. Higher interest rates could pressure consumer demand for durables and discretionary income by raising debt servicing payments. This may certainly impact Dow companies’ bottom lines in the next quarter or two.

It may also inhibit margin debt, which rests at record highs. At the end of July, aggregate margin debt reached $549.9 billion, an all-time record. The ratio of margin debt to GBP now stands at 2.86%, which is easily a record. It eclipses the 2.63% mark in mid-2007 and 2.78% in the year 2000. (Source: “Stock Margin Debt Signal Reaches 5 Alarm Level,” Seeking Alpha, August 30, 2017.)

So, when it comes to key indicators predicting the DJIA forecast, I believe that both central bank balance sheet normalization programs and potentially higher interest rate moves are two of the biggest potential disruptors to the Dow Jones forecast for 2018. The former will directly impact capital inflows while the latter could hamper real consumer demand.

Of course, many more existential factors are at play; the U.S. economy has so many moving parts. But, in the end, the stock market has become largely liquidity-driven. But, when you boil it all down, reduced inflows brought about by reverse QE will impact the market negatively. It simply must.

Historically expansive and overbought, constant QE is required to keep the indexes rising. It’s the jet fuel keeping the plane flying. If this goes into reverse, the primary dealers will lose the bond capital proceeds that they could have thrown back into the market. A cessation of the program will not be like “watching paint dry” as outgoing Fed Chair Janet Yellen has suggested. Quite the opposite; it could be the biggest bull-crushing catalyst that nobody is paying attention to, although everyone knows about it. Normalcy bias is a powerful opiate.

So, without further ado, my Dow Jones forecast for 2018 takes into account the big elephant in the room: quantitative tightening (QT). Just because nobody is talking about it doesn’t make it unimportant.

Dow Jones to Hit 20,000 in 2018

Picking a specific target at a specific date is a fool’s errand. Anything can happen to change the investing landscape over such a vast period of time: sooner-than-unexpected domestic economic turmoil, terrorism, an international sovereign crisis, etc.

Dow jones forecast 2018

Credits:bopav/iStock.com

But, all things being equal, I think that the hundreds of billions of dollars in liquidity being sucked from the system will finally weigh on the market later in the year. With less money flowing into the market, the melt-up cycles will start to move downward. Quite simply, any inflows from the last vestiges of lemming investors and stock buybacks won’t be able to counteract the forces of tens of billions of dollars of liquidity draining from the Fed’s balance sheet.

fedqt

Source: The Federal Reserve

Now, the Dow stock list could get trounced if this liquidity drain is combined with indications that a recession is imminent. That’s the real wildcard. With a current cyclically adjusted price-to-earnings (CAPE) ratio that is the third-highest in history (above 31), a recession will rock market valuations to their core. Remember, earnings typically collapse by 50%–80% during economic recessions. In 2008, earnings fell by more than 92%.

Dow Jones Industrial Average Forecast for 2018

The Dow Jones year-end forecast for 2018 could easily cascade much lower if a recession comes knocking at the door in Q4 2018. I don’t see that happening necessarily, hence my more “conservative” 20,000 forecast. But it’s something to be aware of. By May 2018, this business expansion will be the second-longest in America’s history. A recession is long overdue.

With that said, I believe John Tousley of Goldman Sachs Group Inc when he says that this economic expansion could sustain for a couple more years. Even though the expansion is old chronologically, it remains in good shape. U.S. GDP growth is still peaking, and President Trump may unleash more pro-growth policies (i.e. earnings repatriation) to keep this recovery simmering. This may act as a counterweight to the QT about to take place. (Source: “Goldman’s View: This Could Be the Longest Expansion in US History,” Financial Sense, September 13, 2017.)

So, in a scenario where growth remains robust, say around three percent, the DJIA may not lose much ground. Even though QT will become the dominant force, it will be easier to engineer a soft decline if growth remains strong. Sort of like a balloon deflating naturally over time. That’s the Fed’s dream scenario: somehow drain $2.0 trillion from their balance sheet by the end of 2020, with asset prices only drifting lower in manageable amounts.

If QT and a recession take place by 2018’s end (which is unlikely), the DJIA could take a sustained and nasty fall, well below 20,000. It’s a longshot scenario, but one worth thinking about. This possibility gets more likely beyond 2018, but the worst of QT will have already passed, thus ameliorating the “double whammy” effects somewhat.

In my baseline scenario, where economic growth peaks and starts degenerating below two percent, the market will decline past 20,000 at some point in 2018. QT and decelerating corporate earnings will just be too much for gravity to defy—especially if QT leads to higher interest rates or is combined with more fed funds rate (FFR) hikes.

Higher yields will make the bond market more attractive in a falling equity price environment.

Dow Jones Long-Term Forecast 2018–2020

A Dow Jones forecast for 2018 wouldn’t be complete without prognosticating a couple more years down the road. At this point, it’s all just guesswork, but I’ll try anyhow.

Dow Jones predictions 2019: I believe America will finally enter recessionary water sometime in 2019. This will weight on valuations in most equity classes in this “everything bubble.” But the severity of the decline will depend on how much air QT has already taken out of the ball.

If the market shed 15%–25% by the time the obvious recessionary data rolls in, its impact will be mitigated. If the recessionary data occurs out of left field and/or QT somehow is as benign as the Fed keeps telling us, the drop will be severe.

Dow Jones predictions 2020: A recession will finally arrive. Whether this is induced domestically or triggered by other sovereign actors (i.e. China) is unclear. But something will happen to bring America to heel.

Fortunately for investors, the liquidity drain and rate hikes that began in 2015 give the Fed ammunition to aggressively act again to “save” the economy. That means another round of quantitative easing, direct asset purchases, bond market intervention, etc. to revive the economy after the next recession.

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