Get out your party hats ladies and gentlemen, the markets hit all-time highs this past week.

After increasing equity exposure in portfolios on the 11th, as the markets pulled back to the previous break-out support levels, I suggested a push to new highs was likely.

“The pullback to the previous breakout support level did allow us to add further exposure to our portfolios as we said we would do last week. 

(If you want to see our portfolios they are now online at RIAPRO.net.)

Next week, the market will likely try and test recent highs as bullish momentum and optimism remain high. Also, with many hedge funds lagging in performance this year, there is likely going to be a scramble to create some returns by year end. This should give some support to the rally over the next couple of months. However, as shown above, the short-term oversold condition which fueled last week’s rally has been exhausted, so it could be a bumpy ride higher.

The breakout above the January highs now puts 3000 squarely into focus for traders.”

As shown, the breakout continues to follow Pathway #2a as we laid out almost 6-weeks ago. (Next week, I will update the pathways for the rest of this year.)

While the recent rally has been useful in getting capital successfully allocated, we are still maintaining prudent management processes.

As I noted previously, we continue to use dips in bond prices to be buyers. This is because the biggest gains over the next 5 years will come from Treasury bonds versus stocks.

This is primarily due to the analysis, I penned yesterday on interest rates:

“While the market has been rising on stronger rates of earnings growth, due primarily to tax cuts and share buybacks, that effect will begin to roll off in the months ahead. Tariffs and higher interest costs are a direct threat to bottom line profitability, particularly when combined with higher labor costs.”

“There are several important points to note in the chart above:

1. In the past 40-years, there have only been seven (7) other occasions where rates were this overbought. In each case, it was a great time to buy bonds and sell stocks. (When rates got oversold, it was time sell bonds and buy stocks.)
2. There were only two (2) other periods where rates were this extended above their long-term moving averages. The one that occurred between 1980-1982 began the long-term decline in bond prices. 
3. Economic growth has peaked every time rates got this extended. (Which shouldn’t be a surprise.)
4. Whenever rates have previously pushed 2-standard deviations of their 2-year moving average – bad things have tended to occur such as the Crash of 1974, Crash of 1987, Long-Term Capital Management, Russian Debt Default, Asian Contagion, Dot.com crash, and the Financial Crisis.”

While the markets are currently ignoring the risk of higher rates, even a cursory glance at the chart above suggests that we are near the point where “rates will matter.”

Remember, credit is the “lifeblood” of the economy and with consumer credit now at record levels, and 80% of Americans vastly undersaved, think about all the ways that higher rates impact economic activity in the economy:

1) Rising interest rates raise the debt servicing requirements which reduces future spending and productive investment.

2) Rising interest rates will immediately slow the housing market taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. 

4) The “stocks are cheap based on low interest rates” argument is being removed.

5) The massive derivatives and credit markets are at risk. Much of the recovery to date has been based on suppressing interest rates to spur growth.

6) As rates increase so does the variable rate interest payments on credit cards. 

7) Rising defaults on debt service will negatively impact banks.

8) Many corporate share buyback plans and dividend issuances have been done through the use of cheap debt, which has led to increases corporate balance sheet leverage.

9) Corporate capital expenditures are dependent on borrowing costs. Higher borrowing costs lead to lower CapEx.

10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.

I could go on, but you get the idea.

The issue is not if, but when, the Fed hikes rates to the point that something “breaks.”

However, between now and then, the markets will likely continue to try and push higher as investor confidence continues to swell, pushing investors to take on ever increasing levels of risk, particularly as it appears as if the economy is firing on all cylinders.