Newton’s laws of motion, which rule classical physics, suggest that a body in motion tends to stay in motion until it is acted upon by a force that has equal energy. For years the financial markets have continued to accelerate largely unabated as economic and political forces continued to propel markets higher. However, at some point in the Newtonian natural world, accelerating trends become unsustainable. Opposing forces continue to gather strength, slowing the trends or bringing them to a halt. It appears safe to say that we could be experiencing one of those points as political and global forces and high financial valuations may be combining to disrupt prior Trends and cloud the Outlook.

The Economy

Typically, in a stable environment, the most recent GDP number is a useful measure of economic growth, even though it is three months old before it is finalized. The number from the last quarter of 2024 was 2.4%, which is a respectable growth rate. The most recent semi-real-time GDP Now estimate from the Atlanta Fed that is only four days old tells a different story. It is suggesting that the economy is contracting at a rate of –2.8 %. We will have to see whether this continues, or whether it is a simple artifact generated by the end of the four-year election cycle.

The Federal Reserve’s recent survey of business conditions reports little change. A more up-to-date reading of unemployment remains at an acceptable 4.2% rate, but this measure is usually the last to respond to economic change. The ISM manufacturing index is 50.3, which is still in expansion territory. But the Conference Board’s leading economic index has continued to fall, almost without interruption since 2022. Consumer confidence has dropped sharply again to levels typically seen at the bottom of a recession.

The markets expect two more reductions in the Federal Reserve’s interest rate for federal funds, although the Fed’s policy-making Open Market Committee has paused in the reduction progress for now. They are waiting to see if the imposition of the new administration’s policies and tariffs will re-kindle inflation. The relationship of the short-term and long-term interest rates (“the yield curve”) has normalized, which is good, but such normalization in the past has often preceded a recession, which is obviously bad. It will be interesting to see if the excess government spending of the last few years circumvented the usual recession that follows the curve inversion, or simply postponed it. The Fed continues to soak up the excess money with which it flooded the system in response to the Covid pandemic. It still has further to go.

The Markets

The action of the stock market and the “Magnificent 7” are good examples of unsustainable trends. The “Mag 7”, which has now been dubbed the “Lag 7”, no longer looks so magnificent. An Exchange Traded Fund (MAGS) which tracks these stocks has fallen 25% since mid-December, while the S&P 500 index is down 8% over the same period. That shows that the prior performance of the leaders was primarily volatility rather than value.

Causing this trend disruption, or perhaps as a result, was a significant drop in investor sentiment that essentially mirrored consumer confidence. The American Association of Individual Investors sentiment survey suggests 52% of investors are currently bearish, while only 27% have a positive outlook. Likewise, average market exposure of advisors tallied by the National Association of Active Investment Managers is down to 57%. The good news is that readings like these are often associated with short-term bottoms. The caveat, however, is that they can also be a sign of further longer-term declines ahead.

The calendar may also provide a near-term tail-wind, as April and May of the first year of a presidential term typically offer an improvement over the first quarter.

Newton’s Laws

“Every object perseveres in its state of rest, or of uniform motion in a right (straight) line, unless it is compelled to change that state by forces impressed thereon."

The markets tend to resemble the natural laws of physics. The cycles of the markets are often compared to waves and tides in the ocean. The waves and the markets rush ashore in a “right line” only to be drained of energy by beach friction and gravity and recede again. The waves are changed in size and characteristics by the forces of lunar position, winds, invisible off-shore storms, and local variations of the beach. Sometimes encountering an unexpected Tsunami generated by the force of an unseen earthquake exceeds all prior experiences of a beach dweller.

Trends, or in Newton’s parlance, a “right line” are often just the visible up and down portions of a cycle. If we look at cycles with a narrow field of view and without the benefit of history, we have no way of knowing that a trend is likely to stop as the invisible cycle reaches its peak or trough. Human emotions of panic and greed create financial forces and short-term cycles. The markets react to these cycles and their component trends. This type of cycle can last from minutes to weeks. Economic cycles are also reflected in the markets as political decisions are made and business fortunes ebb and flow. These cycles typically last for months to years. Valuation cycles appear as markets prices go from “cheap” after a wrenching recession to “expensive” after a long period of economic growth. These cycles can last for years to decades. They are characterized by widespread investor avoidance of the markets out of fear, which then evolves to widespread participation, connected by an uptrend, and then back again in a downtrend. A major top occurs when all these cycle peaks occur simultaneously. Unfortunately it is not possible to predict with precision when these peak points will be aligned.

An inexperienced investor, who only has a narrow view of market history, having only encountered a “right line” trend and has not seen how financial forces can change the outcome of a cycle, should be careful. This includes those whose only market exposure has been after 2010. They should be especially wary of the possible outcomes if the government changes its policy to no longer support the markets in the way it has for the last 15 years. If the supportive force underpinning the bull market is removed, Newton’s laws suggest that financial performance may change for years to come, as the financial ocean returns to its normal level.

A reset of government policies and market support suggests that appropriate investing strategies may need to be re-evaluated. A buy-and-hold index fund strategy is essentially deciding to float with the tide. This is fine when the tide is coming in and rising on the beach. If the financial tide will be going out, those who will need to draw upon their investments before the next cycle completes should assure that their strategy prepares for that, so they are not caught in the undertow.