What Every Investor Needs to Know Between Now and 2017

As expected, the U.S. Federal Reserve policymakers at this week’s FOMC meeting voted to keep interest rates unchanged. Central bank rate policies and next week’s U.S. presidential election are the two biggest influences on U.S. stock prices right now.

Well, the FOMC held the line on rates this week, but they’re widely expected to boost borrowing costs in December – thanks to indications the long-moribund U.S. economy is finally accelerating. Indeed, Fed Chair Janet C. Yellen said back in September that strength in the job ranks and a healthy surge in inflation would give policymakers the confidence to raise rates.

This is a time when investors need nothing so much as a roadmap to where the market’s going to actually go in the next weeks and months. Clarity, in other words… and there’s precious little of that to be had from the traditional financial media.

But of course, they don’t have D.R. Barton, Jr. – a 26-year market veteran and pro trader - on their speed dials like I do…

Stocks Are the Focus of the Fed’s “Narrative”

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William Patalon, III: D.R., you have a reputation for market analyses that keep you – and your subscribers – ahead of the curve. Last year, for instance, I remember being ahead of the market thanks to your thinking. Last year, I remember, you were saying that the so-called "FANG stocks" – Facebook Inc. (Nasdaq: FB), Amazon.com Inc. (Nasdaq: AMZN), Netflix Inc. (Nasdaq: NFLX) and Alphabet/Google Inc. (Nasdaq: GOOGL) – were the only ones that mattered to investors at that time.

Indeed, we shared those insights – and others – with Private Briefing readers. You made good recommendations for your subscribers with this focus, and then the markets finally came around to your way of thinking, pretty much in time for you to shift the other way.

D.R. Barton, Jr.: It's interesting how those "Big Four" FANG tech stocks led the market… retrenched… and led the market yet again. I think all four can still be bought on pullbacks, especially for those with longer investment horizons.

WP: As I've chronicled to my subscribers, I see big things for Facebook – for those with that long-term horizon you mentioned.

DRB: Indeed, Bill – as you and I have discussed many times …

WP: Your next great call had to do with the U.S. central bank. Early this year, you said that the story of the U.S. Federal Reserve – the so-called "narrative" of the U.S. central bank – was the "only narrative that mattered." In recent months, I've heard other analysts, observers, traders, and mavens make the same comment.

Before we delve into that a bit, explain what you mean by the "Fed narrative"… and what that meant for the markets.

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DRB: I love that word "narrative." It's so rich. In the way I'm using it, the term means much more than just a "story." It's more like a major plotline – or the "story arc" – of the financial markets. In essence, the Fed narrative – or, more broadly, the global central bank narrative – is the tale that dictates whether stock prices rise, fall, or run in place.

WP: And as an investor, if you understand that, you have gone a long way toward understanding what's happening in the markets and what will happen in the markets.

DRB: Exactly – that's why it's such a powerful concept.

WP: And the narrative here is that…

Here Comes the Narrative Twist…

DRB: … the "accommodative" (supportive) monetary policy is trumping all the bad news out there. Sure, China's debt bubble is worrisome. And of course the six-quarter-long U.S. corporate "earnings recession" has many people thinking bearish thoughts. But as long as the central banks provide both a perceived safety net under the markets – and plenty of added stimulus to the system – stock prices, and the market in general, will continue to hover near the top of the chart.

WP: Here's where this narrative gets interesting. You've put a twist on this Fed saga… you've identified a shift in policy. What is it that you're predicting?

DRB: I believe that starting with today's FOMC meeting announcement, the Fed will start positioning itself as more hawkish (less accommodative). There's almost no chance for a Fed interest rate hike at the end of the two-day meeting today. But I think policymakers will clearly signal that rate hikes are coming – starting in December.

WP: Which is when these folks meet again.

DRB: That's right, Bill. And here's the key point: This "signal" – this "hint" that rates are going higher – will be very well received by investors, by the markets.

WP: So explain exactly what it is that you're seeing that's prompting you to "see" this shifting Fed stance.

DRB: Let me start my answer with a bit of a foundation. You see, Bill, there are three very specific things that scare the Fed to death. I'm talking about:

Financial instability or perceived instability.

Making disruptive moves.

And being wrong for too long.

WP: And as you've said to me during our weekly briefings, keeping interest rates at their present, historically low level has the potential to make all three of those nightmare scenarios come true at once.

DRB: Exactly, Bill. It's the worst of all possible outcomes – the future that the central bank fears the most.

WP: I just mentioned our weekly telephone briefings – during which you share some of the most intriguing thinking I come across. Here's one of your observations that I think is really relevant here. You've said to me that most folks – most investors – think of the Fed as a kind of "faceless monolith."

DRB: Like the monolith in “2001: A Space Odyssey”.

Markets Could Get Dragged Kicking and Screaming Toward Normalcy

WP: As you said, though, D.R., this perception couldn't be more wrong. In reality, the Fed is made up of people – people like you and me – with emotions… with preconceptions… with biases… and, as you pointed out a moment ago, some very real fears.

So when those policymakers look at the markets, look at the challenges and look ahead six, 12, or 18 months, what do you think that they see? What are they predicting? What are they afraid of?

DRB: They can see the writing on the wall. All of the assets that have been added as financial stimulus to the markets have to be "unwound" – or reabsorbed.

WP: And that requires a deft touch?

DRB: Absolutely. A very deft touch, in fact. If that happens too suddenly, or happens too late, it could result in an economic "hard landing" – or, worse, a 2008-style financial meltdown.

So the Fed would like to ease us back toward normalcy – as denoted by moderate interest rate levels. Because, if the central bankers fail, they're terrified the markets will do the "normalizing" for them.

WP: And when you say "the markets will do the normalizing for them," what – precisely – do you mean?

DRB: Markets have one role. Whether it's for used cars, tomatoes at the farmers' market, or beach houses, the role of the "market" is to find the "market clearing price" – that point on the supply and demand curve where buyers and sellers agree on a price.

The tool the markets use is volume. If the price is too high, the buyers back away and there's no volume. If the price is too low, the sellers stop offering their wares and the volume dries up. There is an equilibrium point where buyers and sellers both believe they're getting a "fair price" and higher transaction volumes occur.

For too long, stock prices have reflected an inflated value caused by central banks' ultra-supportive monetary policy.

If the central banks just kept up the overly zealous purchase of bonds on the open market and the equally outrageous zero- to negative-interest-rate policies ad infinitum, eventually market participants would find themselves in an asset bubble. And like every asset bubble before, it would pop. Prices drop radically. Market-created "normalizing" or "correcting" is rarely pretty, as we saw in the bursting of the internet “Dot-Bomb” Bubble in 2000-2001 and the Real Estate and Debt Bubble in 2007-2008.

WP: Okay, so we've created a very intriguing foundation for my subscribers. Let's flesh this out a bit.

Given all that you've told us, when you look at the economy – both domestic and global – what do you see, D.R.? What are you predicting? Are you bullish… bearish… worried… sanguine?

DRB: In the near term and out to the intermediate term, I'm a bit neutral. Unless we get a surprise in the U.S. elections, I think the markets will take a "wait and see" attitude with the new administration.

WP: I can almost hear the "however," here …

There Are Some Wild Cards at Play in This Election

DRB: You're very perceptive (laughing). You see, Bill, there are two election outcomes that could be very disruptive for markets.

WP: And they are?

DRB: As I see it, there are two "spoilers" to watch for and worry about. They are:

A Democratic sweep of the White House, the Senate, and the House of Representatives. This type of left-leaning mandate would be worrisome for the stock markets and cause a big sell-off. Gold and bonds would probably get a temporary lift, as they tend to do in times of uncertainty. From my analysis, I see the presidential race getting tighter, though I still believe it's clearly Hillary Clinton's to lose… she seems to keep finding innovative ways to attempt just that. The Senate is a toss-up. And it looks like Republicans are strong favorites to hold onto the House.

The second disruptor would be a come-from-behind Donald Trump win. But what would tip the stock market into a potential meltdown mode would be a Trump victory combined with immediate antitrade rhetoric, especially with China. What makes this a real possibility is the campaign rhetoric Trump employed – rhetoric that reached the level of full-blown campaign promises. Again, such a move would most likely cause a temporary flight of uncertainty into bonds and gold, raising their prices.

WP: So if Trump wins – and maintains or ramps up what you've referred to as his "economically bellicose" posture on global trade before he takes office – you're saying…

DRB: … it's "look out below" time.

WP: In other words, you believe the markets would retreat significantly.

DRB: That's right.

The Full Forecast for 2017

WP: So with the Fed move prediction you're making – and the analysis you've offered here – what's your expectation for the stock and bond markets? What will be strong? And what will be weak?

DRB: Bonds have had a way of confounding pundits throughout this quantitative easing (QE) cycle. If we get the expected quarter-point bump from the Fed next month – and moderate language to go along with it – I predict that bonds will fall much less than most of the prognosticators are saying. Even so, for the long term I'm actually quite bearish on bonds – in fact, I've been short bonds in Stealth Profits Trader since July.

WP: For stocks?

DRB: For stocks, I expect a bumpy 2017 – with prospects for only a modest return… only a modest upside. And I give us a much higher than normal chance for a significant correction in the next 18 months.

WP: By "significant drop," what are you saying – specifically?

DRB: I'm talking about a drop of 20%, 30%, or even more during the time frame I just delineated.

WP: So a true bear market.

DRB: Correct… a true bear market – a decline of 20% or more.

WP: So what are the biggest opportunities for investors? What are the biggest threats?

DRB: I believe the biggest opportunities lie in capturing our fair share of the short- to intermediate-term moves in the market. The biggest threat is for investors who don't have a full plan for navigating this stretch I see.

WP: By a "full plan," you're talking about having an "exit plan" – or a way to deal with the downturn. And also what you refer to as a "reentry strategy" for cashing in on the bargains that will be there.

DRB: Absolutely. You have to have an idea of what you're going to do when the market pivots.

WP: So what's the strategy for playing this? Is there anything you like a lot? Fear a lot?

DRB: I like following the "sector rotations." In the first half of the year, we made a lot of hay in utility and defense stocks. Now tech has been back in favor – and we've been working the big tech names: Alphabet/Google and one of your favorites, Facebook.

WP: In fact, both those stocks are on the Private Briefing "Shopping List" of stocks to "Accumulate" on sell-offs.

DRB: And you see, Bill, that's an example of just what I'm referring to when I talk about an "exit" and "reentry" strategy. There's never just one way to invest, never just one strategy that works. But you have to find a strategy that works for you, that fits your risk profile and emotional makeup. And you have to implement it consistently.

WP: Okay, so getting back to the rest of my earlier question: What do you fear?

DRB: What I fear is a "liquidity squeeze." For years, now, the central banks have been like an "asset spigot" – with the valve wide open in a manner that provides free-flowing liquidity. That's buoyed financial assets – like stocks. But I believe the next big drop we see will come when liquidity dries up – or just even slows down. Your insistence on "trailing stops" for positions is a great stress-free way for investors to have their protection in place when that kind of event happens.

WP: Thanks, D.R. This was great – as always.

DRB: You're welcome, Bill. Happy to do it.

Bill writes Private Briefing every weekday morning. Click here to learn how to get his recommendations for yourself.

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