Usually it pays to be cautious, but also to remember that long term economic power and dynamism in the United State has fueled stocks to gains hard to find elsewhere. So with that in mind, I'd like to list some of the key current concerns for investors.
The FED carried on the largest prop trade in history when it implemented its quantitative easing programs following the financial crisis. It has since begun raising short term rates, and soon will be reducing its bond portfolio. They are removing money from the financial system and this has deflationary effects. In a nutshell, that can be bad for the stock market if it's not offset by economic growth.
I believe that is what the FED expects. They believe that the tax changes and the prospect of infrastructure spending, will have inflationary pressures, and can absorb the deflationary shock of tightening. What happens if they are wrong? They tighten us into a recession. I think this is the biggest risk going forward. The FED always raises us into recessions. It's just a matter of where at. Since the supply they are taking out of the system is massive, it may speed up the time it takes for them to slow down out economy. [Note: This provides a counter pressure to the following fear of Inflation.]
The steel and aluminum tariffs (and other tariffs) have the potential to start a trade war with China. Trade Wars are almost by definition inflationary. You are removing a cheaper (foreign) supplier and replacing it with a more expensive (domestic) supplier. It may benefit workers in that industry, but anyone that uses that product will pay more. That will cause upward price pressure and may boost inflation numbers going forward.
There is some debate about whether this is simply a negotiation tactic by President Trump. But that ignores the fact that the Chinese are terrific negotiators. They may not be easily persuaded to accept worse trade conditions, even if it would be fair. This is a looming issue that should pay out in coming months.
While inflation has not been a concern for over a decade, the recent stock market gains combined with the tax legislation, have fueled some speculation about inflation. Bond rates have risen quite a bit lately, and it was probably caused by inflation risks.
In addition to the economy naturally heating up, the recent tax legislation will likely result in some added inflationary pressures because companies will likely use the extra cash to increase wages, construct plants, and perform buybacks. This will increase demand, which results in upward pricing pressures.
War is always a possibility, but give the current administration and its recent cabinet changes towards hawks, and it seems that a major war is more of a threat now than at any time in the past decade. North Korea is always a wild card, but they now have nuclear capabilities and the upcoming meeting with Kim Jong Un could lead to unpredictable scenarios, especially considering Trump and Kim Jong have a history of belligerent actions/words. This is a low risk event, but still higher than it has been for a long time.
Finally, perhaps the most important element is valuation of the market. I like to look at Robert Schiller's CAPE ratio. Below is a chart of it. You can see that we are historically pretty high. Some could say that the mean ratio has been rising, and that we aren't in bad shape. I would disagree. If you consider that interest rates are now rising, especially on the short end, high multiples make less and less sense.
With rates rising, and volatility rising, portfolio managers should start to reprice risk. This means a few things, but one of them is that they will be willing to pay incrementally lower prices for company earnings, thus lowering P/Es.
It is hard to tell when that will happen, but given the list of risks above, any one of them could provide the "excuse" to selloff. That is what we've seen the past few weeks. It is what we could continue to see. Who knows where the market will decide to reprice P/Es to? Not me.
So what is an investor to do? They can allocate more of their portfolio to cash. If they are hesitant to do that they can buy protection in the form of SPY puts. At a minimum, investors should understand the value of a properly diversified portfolio. In any case, it pays for investors to not stick their head in the sand.
These risks may not result in a bear market, and they may even counteract each other (quantitative tightening vs inflation), but regardless, there are a lot of swirling factors at play and this far into an economic cycle it's smart to pay attention.
Disclaimer: As always, the above post should not be construed as investment advice because individual circumstances vary.
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