Market Commentary - January 2018
“It's definitely moving.”
- Ventura County Sheriff's Capt. Garo Kuredjian discussing the Thomas Fire on December 7, 2017.(1)
Right he was. From Fillmore all the way to Santa Barbara with damaging stops in Ventura, Carpinteria and Montecito. Three weeks later containment finally reached 90%. What caused this to become the largest fire in California history? Is the blazing stock market on a similar path? Will Tax Reform add gasoline to the fire?
We want to preface this conversation by expressing our most sincere sympathies to everyone who lost their home, and our gratitude for all the efforts that went into minimizing property damage and protecting human lives. We are using the fire metaphorically, and are not suggesting anything positive about the actual Thomas Fire.
Elements Necessary for Fire
Fires require four elements including a spark, fuel, heat and oxygen. Only the origin of the Thomas Fire remains uncertain. Heat and oxygen were plentiful, courtesy of Santa Ana winds. As for fuel, the fire rolled through parts of Ventura and Santa Barbara Counties that hadn’t burned in up to 100 years. (2)
The Stock Market Has Been “On Fire”
At the bottom left of the graph below we have circled the last month of the Great Recession, January of 2009. The market turned upward and, despite a few minor pauses, has roared for nine consecutive years.
Elements of the Bull Market
Spark: With a name derived from its underground store location at the Downtown Crossings subway station in Boston, Filene’s Basement gained fame from pioneering a novel sales technique. They simply lowered the price of a product every single day until a buyer became seduced. The stock market took a chapter from Filene’s marketing plan starting in late 2007 with the S & P 500 at around 1,500, when it began dropping almost every day. When the market finally bottomed, at close to 700, the half-off sale proved irresistible. Extremely low valuations provided the catalyst for the current bull market.
Fuel: Old trees and dry shrubs kept the Thomas Fire burning. Synchronized global economic growth, super low interest rates and benign inflation have all fed this bull market. The Organization for Economic Cooperation and Development (OECD) counts the U.S., U.K., Korea, Mexico and Turkey amongst its 35 constituents. Uniquely and without exception, every member country experienced economic growth in 2017. (3) Despite a stellar year from the U.S. stock market, non-U.S. stocks did even better. (4) Inflation expectations stayed below 2% for most of the year, allowing interest rates to remain depressed. Low interest rates: (1) Make bonds less competitive, (2) Allow marginal companies to borrow and stay afloat and (3) Provide ample cash for both repurchasing stock and making acquisitions. The global thirst for yield, symptomatic of the suppressed interest rate environment, helps support not only stock prices, but also lower-quality bonds and triple-net commercial real estate as well.
Oxygen: We have previously written about Newton’s First Law: an object in motion will stay in motion, with the same speed and the same direction, unless acted upon by an external force. In the stock market, this is referred to as momentum. The red line in the chart below represents the impressive S & P 500 for the year of 2017. The blue line represents an index of momentum stocks. (5) Deploying a momentum strategy, or buy it because it’s going up, produced considerable rewards.
Heat: Sentiment represents the heat. The S & P 500 has gained about 79% in the past five years while earnings have grown by only 16%. (6) Thus, most of the market returns have come from the willingness of investors to pay an ever higher multiple on earnings.
In 1992 David G. Shulman, then a strategist with Solomon Brothers, coined the phrase, “Goldilocks Economy” meaning not too hot and not too cold. (7) We need enough fuel, heat and oxygen to keep this bull market glowing, but not so much that it stirs the embers of inflation and extinguishes low interest rates.
Unemployment, at 4.1%, is at the lowest level since 2000. (8) When the Federal Reserve Board voted to increase interest rates last month, they provided the following rationale: “Allowing the labor market to overheat would raise the risk that monetary policy would need to tighten abruptly at a later stage, jeopardizing the economic expansion.” (9) Too much stimulation to the economy would likely result in the Fed raising interest rates faster, or more frequently than already planned in 2018. (The Fed is on record for expecting three additional hikes this year and two more in 2019, on top of the three in 2017.) (10)
Conversely, failure to stimulate the economy would pressure our ability to service debt. As the graph below depicts, that bill is growing into a problem. (11) With debt now exceeding 100% of our gross domestic product (GDP), the US has joined a small and undesirable club that includes Japan, Greece, Italy and Portugal. (12)
Sentiment warrants attention. As previously noted, valuations have risen steadily for several years. The S & P 500, which has historically experienced a correction of at least 10% every 20 months, never dropped by 5% in 2017. Indeed, the S & P 500 did not experience a single losing month in 2017. The average volatility in price was the lowest level since 1970. (13) Complacency toward risk sometimes leads to unwarranted market price elevation, which can eventually turn away shoppers.
Mountain High Ski Resort ran a clever radio commercial several years ago. It started with a serious tone and proclaimed that “There are only four things you have to do in life. You have to eat, sleep, work and ski.” The ad suggested coffee is a great replacement for sleep and, after a little weaving, reached the conclusion that skiing is the only critical endeavor. We are going to co-opt their methodology and say that the 478 pages of the recently passed tax law, as it relates to the stock market, can be distilled down to a few key points:
- The taxation of interest, dividends and capital gains remains unchanged and the Medicare Surtax remains.
- There are still seven income tax brackets; tax rates drop modestly for all individuals.
- “Ultimately, how the bill shakes out for each individual or family depends on income and wealth level, family size, which state you live in, and whether you own a home, among other factors.” (14)
- The Joint Committee on Taxation (JCT) staff have estimated that the net revenue effect of HR 1 will be to increase the on-budget federal deficit by $1.456 trillion over 10 years. (15) JCT estimates are considered “static” and do not incorporate the potential added tax revenues from increased economic growth.
- The most dramatic changes accrue to corporations that will see a reduction in their top tax rate to 21% from 35% and a “one-time repatriation tax on corporate earnings held overseas.” (16)
Does the Tax Bill Add Fuel to the Fire?
Despite the reality that new tax law is by no means the only influence on financial markets, for discussion, we can still isolate the expected impact from those changes.
“The drop in the corporate tax rate from the current 35 percent to 21 percent will save U.S. companies more than $1.3 trillion over 10 years.” (17) Where will that money go? In a survey, 300 executives were asked this summer what they would do, and the top two responses were paying down debt and buying back stock. (18) Good for the stock market, not necessarily consumers. Yet, upon passage of the bill, A T & T, Boeing, Comcast and Fifth Third Bank all announced plans for some combination of increasing U.S. investment and/or worker pay. Corporations will likely end up spending tax savings on a combination of capital investments, higher wages, stock buybacks, higher dividends, and debt repayment.
What is the bond market telling us? Consider the change in Treasury bond yields that occurred during 2017: (19)
Jan 3, 2017
Dec 29, 2017
1-Year U.S. Treasury Note
10-Year U.S. Treasury Note
Short-term rates almost doubled during the year, taking the brunt of three Fed rate hikes designed to keep the fire under control. Normalizing money market yields likely prompted many investors to notice this. Longer term bonds, typically a proxy for inflation expectations, were flat for the year.
What can we do to maintain the glow when we have no control over the heat, the fuel or the oxygen? We use fire lines in the form of your Investment Policy Statement, limiting your exposure. We use controlled burns by maintaining fixed income and cash. We use more fire- resistant materials: individual securities with an emphasis on staying power over rocket power. Finally, we mop up when necessary, by rebalancing into areas that have been previously burned, knowing that the cycle will repeat itself. Discipline and vigilance are essential parts of our mission on your behalf.
As for our market prediction in 2018, we agree with Capt. Garo Kuredjian…it’s definitely moving!
- Los Angeles Times; December 7, 2017
- Los Angeles Times; December 10, 2017
- “If world is drifting apart, it isn't happening in economic growth”. Reuters; December 5, 2017
- Japan up 23.1%; Eurozone up 28.35%; Emerging Markets up 31.97%.
- Standard & Poors 500. MTUM is the iShares Edge MSCI USA Momentum ETF.
- SP was 1,498.11 on 1/1/13 and 2,673.61 on 12/29/17. EPS grew from $107.31 to approximately $124.95. Source: Standard & Poors.
- “Finding Goldilocks”. CNBC; October 13, 2015
- Bureau of Labor Statistics.
- “Fed Raises Rates, Eyes Three 2018 Hikes as Yellen Era Nears End”. Bloomberg; December 13, 2017
- Transcript of Chair Yellen’s Press Conference December 13, 2017. www.FederalReserve.gov
- FRED: St.LouisFed.org
- Central Intelligence Agency; CIA.GOV
- “The hidden reason why stock market volatility has been so low”. Market Watch; January 4, 2018
- “What the New Tax Law Means for You”. Barron’s; December 23, 2017
- “President Signs Tax Bill”. PriceWaterhouse Coopers. www.PWC.com
- “2018 Tax Reform Bill Passes”. CPA Practice Adviser; December 17, 2017
- “Here’s How the Tax Bill Will Hit Your Wallet”. CNBC; December 19, 2017
- Survey done by Bank of America Merrill Lynch. “Shareholders Will Be the Real Winners in the GOP's Corporate Tax Cut. Fortune Magazine; December 20, 2017
- U.S. Department of the Treasury. www.Treasury.gov