Here’s what could go wrong with stocks at record highs

A man walks past a television screen showing file footage of a North Korean missile launch, at a railway station in Seoul on April 5, 2017.

A man walks past a television screen showing file footage of a North Korean missile launch, at a railway station in Seoul on April 5, 2017.

Jung Yeon-Je | AFP | Getty Images
A man walks past a television screen showing file footage of a North Korean missile launch, at a railway station in Seoul on April 5, 2017.

The midsummer market is a Goldilocks market, but it’s about to head into what can be two of the worst months of the year for stocks and there are plenty of risks to the rally.

Robust earnings, a fairly easy Fed, super-low volatility and a global economic recovery are among the many things that look just right for the market and are helping it set new highs day after day.

But Goldilocks could get burned by any number of unforeseen developments, from the geopolitical to policy induced.

First of all, the stock market has not had a correction of any size since the 11 percent sell-off that ended in February 2016. Investors are also overly exuberant and volatility, as in the VIX, has been near record lows — a contrarian’s sign that trouble could be brewing.

“We don’t need to have one but it wouldn’t surprise me if we did have a pullback,” said Jeff Kleintop, chief global investment strategist at Charles Schwab. Some investors have been hoping for a sell-off, and he said even with a 5 to 10 percent or greater correction it would be over quickly.

“There’s still people looking to buy in on the dips, and people have a lot of cash. I would think it would be fairly short-lived,” he said.

Kleintop said when the market runs out of earnings news, other forces could take hold and he has a list of concerns that includes the tensions with North Korea and the administration’s trade talks. That also coincides with August and September, historically two of the worst months for stocks.

“You’ve got oil, geopolitics and trade, three market-sensitive issues on the docket in August,” Kleintop said.

“We’ve got the hurricane season picking up in August. That could influence oil prices and it looks like it could be a more aggressive season this year,” he said. Both a big spike in oil prices, or another big drop would be negative for stocks. “We’ve also got … really the first substantive NAFTA meeting on Aug. 17 through the 20th.”

NAFTA is the North American Free Trade Agreement that is being renegotiated with Mexico and Canada, and if there are signs of protectionism beyond the usual rhetoric, that could be a problem for markets.

Kleintop said tensions with North Korea, which have really not been a factor for the U.S. stock market, could become more worrisome. “We’ve got the potential for a North Korean missile test again in August. That could shake the market a little as tensions continue to heat up.”

Marc Chandler, global head of currency strategy at Brown Brothers Harriman, said North Korea has become a greater concern to markets because of its increased missile capabilities, and the fact that it is the Trump administration’s first serious foreign policy challenge.

“It looks like China is growing less patient with North Korea,” said Chandler, noting press reports have said China is boosting its border defense. The Wall Street Journal reported that China was taking the action in part out of concern that a U.S. strike on North Korea that could destabilize the country.

Chandler said another concern the market is not really focused on is the Himalayan border dispute between China and India, where there have been skirmishes.

“Most of these things are low level, but Korea I think could get bad quickly,” said Chandler. He said if there is a U.S. military response, it would be a big deal for markets. “Russia is siding with North Korea, and Russia and China have both said they want a peaceful solution.”

Chandler said there’s also some risk for markets this week from North Korea. Thursday is the 64th anniversary of the cease-fire that ended the Korean War, and he said North Korea has used this date as an opportunity to show off its military might.

Washington could also become a factor for markets as well if Trump administration efforts to raise the U.S. debt ceiling run into trouble in Congress. Some strategists say there could be some market turbulence around congressional efforts to reach a budget resolution this fall with talks on that and the debt ceiling picking up in September.

Strategas Research’s head policy analyst, Daniel Clifton, says he calls the budget debate the “spinach” portion of the Republican agenda, the part that Congress has to work through before it can get to tax reform. The budget for fiscal 2018 contains reconciliation instructions for tax reform which would allow the Senate to pass tax policy with just 51 votes.

“Failure to raise the debt ceiling could lead to financial market complications, as we learned in 2011. We expect both the budget and debt ceiling to be completed, but rarely does the process invoke confidence in policy-making,” wrote Clifton. If stocks sell off, however, he sees it as an opportunity to buy the dip.

“We’ve gone a long time without a correction, but that’s something you could have said three months ago. Just because you’re at the roulette table, you could be overdue for black but you keep coming up red. Concerns about valuations have been around for a year now,” said Paul Hickey, co-founder of Bespoke.

Hickey said one thing that could trigger a correction is if the economic data begin to make it seem that the Fed is going in the wrong direction, or is even behind the curve and has to play catch up with interest rate hikes. The market is currently not convinced the central bank will raise rates again this year, as it has forecast.

But the Fed is expected to begin the process of unwinding its balance sheet in August, by buying fewer Treasury and mortgage securities. Some strategists say that process could spook the market if it causes interest rates to rise.

Hickey points out that the S&P 500 has actually fared worse in the seven summers since the bull market began, declining an average 1.7 percent in August.

Source: Bespoke

In the past 20 years, August has been the worst month of the year for the Dow and the S&P 500, both lower half the time and averaging declines of about 1.5 percent, according to analytics firm Kensho. September has been the third worst month for stocks, with the Dow down an average 1 percent and negative 55 percent of the time. The S&P has been down an average 0.75 percent and was lower half the time in September.

But for now, Hickey doesn’t see some of the red flags that would signal a correction. “The high-yield market has been holding up well,” he said. Earnings have also been strong, with second-quarter profit gains coming in at about 10 percent, according to Thomson Reuters.

“It’s not a bright green light, but it’s not flashing red either,” he said. Hickey said other summers have had their unexpected surprises, like 2015 when China’s economy was slowing or 2014 when there were concerns about ebola.