Taxes Go Down, Markets Go Up
A Financial Teeter Totter
Riding on the tailwinds of modest, sustainable growth, low inflation, and an ever-slightly-improving jobs picture, the markets were presented (slathered, really) with icing on the cake in the form of the tax package passed in December. Let's take a moment to review how various indices fared for the past quarter and for the year:
Let's take a look at how various indices fared for the past quarter.
|Index||4th Quarter||2017 Year to Date|
|Dow Jones Industrial Average (the Dow)
|S&P 500 Stock Index (the S&P 500)||+ 6.1%||+ 19.4%|
|NASDAQ Composite||+ 6.3%||+ 28.2%|
|Russell 2000 (small companies)||+3.0%||+ 13.1%|
|Dow Jones Global Stock Index (non-US)||+ 4.9%||+ 24.6%|
|10-Year Treasury Bonds||+ 0.2%||+ 2.5%|
|Commodities Index (Reuter-Jeffries CRB)||+ 6.8%||+ 10.2%|
|U.S. Dollar Index (WSJ Index)||- .4%||- 7.5%|
All index values come from the Wall Street Journal. Stock indices do not include dividend return..
While the markets had already advanced nicely before the new tax legislation was enacted, the news had the effect of waving a red flag in front of market bulls--and they charged. The Dow rocketed ahead over 10% in just the last quarter, notching a gain of 25% for the year. The broader S&P 500 was not far behind with a robust quarterly gain of 6% and was up over 19% for the year. The tech-heavy NASDAQ continued its winning ways, up over 6% for the quarter and pegging a dominant 28% gain for the year. Small companies had what we would normally describe as a good quarter but "only" gained 3% for the quarter and "only" 13% for the year. Perhaps this was due to small company stocks outpacing the rest of the indices in the preceding year. Foreign markets had a banner year as well, gaining nearly 5% for the quarter and almost 25% for the year. Foreign economies are experiencing growth rates that are actually stronger than ours, and the advance of foreign stocks reflect this—as well as a declining dollar. Bonds declined slightly for the quarter and posted a very modest gain of 2.5% for the year. As interest rates rise, the market value of existing bonds falls. The index return represents the offset between better income return but loss of value of the bonds. Commodities rebounded during the quarter, aided by the large increase in oil prices and the fact that many commodities are valued in US dollars. (As the dollar declines, it takes more of them to represent the value of one barrel of oil or one ounce of gold.) The dollar declined a whopping 7.5% this past year—a testament to interest rates increasing at a faster rate overseas than our rates are increasing. Money has been flowing out of US dollar-denominated securities and into investments abroad to earn more interest overseas as well as providing the capital needed to support economic growth abroad. It may also reflect wariness in what is coming out of Washington DC these days.
Where We Are Now
With a few qualifications, we are pretty much "all systems go" on the market front at this time. We continue to experience a good and sustainable rate of growth with only modest inflation. The economy grew at a 3.2% rate in the 3rd quarter and early estimates for the 4th quarter are coming in at a reduced but healthy growth rate of between 2.3% to 2.7%.
Stock valuations--stock prices compared to the earnings per share--remain high, reflecting the anticipation of increase profits from economic growth and tax savings. The last-reported unemployment rate declined to 4.1%--a 17-year low. The Federal Reserve Bank (the Fed) raised short term interest rates again in December--the 3rd time in 2017--and the Fed expects to raise rates another three times in 2018. Inflation has ticked up a bit but remains muted. A declining dollar makes our exports cheaper to foreign buyers but makes our imports from foreign sellers more expensive. This could be inflationary if the trends continue.
The tax package recently passed will serve as a big artificial sling-shot for corporate profits, as expressed in terms of after-tax earnings. The new law has many features which affect nearly all of us differently, but those who gained the most are corporations and those fortunate enough to have very high incomes. With corporate income tax rates being significantly slashed, after-tax earnings will get a huge boost. It represents a new "source" of cash for corporations that would otherwise have been paid out as taxes. This has been a source of support for the surge in stock prices. Some companies will simply buy back their stock, declare special dividends, or pay off debt. Some recent headlines have touted several companies' plans to increase worker wages. I may sound cynical, but the special, one-time $1,000 payment per worker that corporations have so proudly announced adds up to a 50-cent-per hour raise paid up front—then back to the previous level of pay. I'm not being callous. I know it's very important for many families to receive a "gift" of $1,000, but it should be placed in perspective. Many economists expect the party from the tax benefits to last a year or two, then leave us with the bill for the cleanup—a burgeoning deficit. Large deficits have the tendency to move interest rates up. Think of it as supply and demand. The federal government must issue more bonds to raise the money ("monetizing the deficit") and the increased supply reduces prices paid for bonds. Lower bond prices equates to increased interest rates. Unless some creative financing is identified, the funding for infrastructure spending may have been forked over to corporations with the tax bill.
The current bull market is over 8 years old (only the 1990 – 2000 rally was longer) and one must ponder how much longer the party can go on. However, after fretting about it this past year, I would have to agree with a recent article by Richard Barley in the 1/9/2018 issue of the Wall Street Journal in which he stated: "in the short term stock valuations aren't a good guide to market action. Until investments get a clearer signal on the balance between growth and inflation, the old playbook is the one to go by".
Looking ahead for the year, the majority of signs are positive for continued economic growth in 2018. Incrementally modest interest rate increases by the Fed should keep inflation in check. International economies may continue to outpace US growth, which may result in further declines in the US dollar. This would continue to help exporters but could also result in inflationary pressure as imports cost more dollars. Gains in employment will likely level off at or slightly below current levels. Markets should be stable although they could be subject to correction should investor confidence be shaken or the ongoing political risk comes to a head.
As always, I will continue to follow the markets closely and take appropriate actions within client accounts to manage risk and return in accordance with each client's Investment Policy Statement.
Please feel free to call with any questions or comments.
Craig S. Limoges CFA, CFP, EA
Congratulations to Richard Thaler for being awarded the Nobel Prize in economics last Fall. An economics professor at the University of Chicago, his important area of work has been in behavioral economics—noting that investors can't be described as cold automatons but rather they are more often influenced by the psychological aspects of decision-making.I had the pleasure of meeting him at a national investment conference some years back.