2017 Stock Market Review and Outlook for 2018

2017 Stock Market Review and Outlook for 2018

by Andy Byron on Jan 25, 2018

Market Report

The passage of corporate tax cuts late in the year provided a positive surprise for U.S. stocks and helped drive another strong quarter of returns, bringing full year returns to over 20% in the S&P 500. The S&P 500 now stands at about three times its value of 677 at the last market bottom on March 9, 2009. Domestically, growth stocks were the big winner for 2017, with the large capitalization Russell 1000 growth index up over 30% compared to less than 14% for the Russell 1000 value index. International stocks were the top performers for the year, with developed international markets up 27.2% and emerging markets up an astounding 37.3%. Better than expected growth internationally helped drive stock returns and also weakened the dollar relative to most other currencies, further boosting returns for U.S.-based investors.

 

Absent an extraneous shock, 2018 looks to be another good year for stocks, while rising interest rates may pressure bond returns and could potentially pressure stock prices later in the year. Although investors have concerns about the magnitude of the rally in stocks and the current price levels, valuations have almost no relationship to returns over a one- to three-year period. When stocks are expensive they typically remain expensive for multiyear periods, as economic strength drives profits and investor confidence, which extends the bull market. For long-term investors, the best returns are typically generated in the last two years of a bull market. Trying to time stock markets on valuation typically leads to missing out on an important part of the market cycle and damages overall returns. Despite being in what is very likely the late stages of a bull market, the best strategy for most long-term investors continues to be a balanced portfolio that has a healthy level of participation in stock returns but still protects against inflation and other shocks through noncorrelated asset classes.

 

 

Major Stock & Bond Indexes (Total Return)

Lipper Mutual Fund Peer Averages (Total Return)

 

4Q17

2017

 

4Q17

2017

S&P 500 Index

6.6%

21.8%

Large-Cap Core Funds

6.3%

20.7%

Russell 1000 Growth

7.9%

30.2%

Large-Cap Growth Funds

6.4%

29.6%

Russell 1000 Value

5.3%

13.7%

Large-Cap Value Funds

5.8%

15.9%

Russell Midcap Index

6.1%

18.5%

Mid-Cap Core Funds

5.5%

15.8%

Russell 2000

3.3%

14.7%

Small-Cap Core Funds

3.7%

12.6%

MSCI ACWI Ex USA NR (USD)

5.0%

27.2%

International Large-Cap Core

3.9%

25.0%

MSCI EM (USD Gross)

7.4%

37.3%

Emerging Markets

6.3%

34.5%

S&P U.S. REIT TR

1.4%

4.3%

Core Bond

0.3%

3.4%

Barclays US Agg. Bond (3-5yr)

-0.4%

1.8%

Intermediate Municipal Debt

0.3%

4.3%

 

 

TAX CUTS

 

Republicans in the House of Representatives and Senate were able to work together and quickly pass tax cuts aimed primarily at reducing the corporate tax rate. Under the new legislation, corporations will receive a cut from a marginal tax rate of 35% to 21%, and profits generated overseas can be brought back to the U.S. or “repatriated” at a tax rate of 15.5% rather than the full 35%. Although corporate tax code reform had been a priority for both Republicans and Democrats, the Republican version passed along party lines.  The short-term impact of the tax cuts on stock prices should be quite positive, as lower taxes translate into greater profits, giving stocks further valuation support. Entering 2018, the S&P 500 index was trading at 18.2 times estimated 2018 earnings. If the lower tax rates provide a 10% boost to corporate profits, this multiple of forward earnings is reduced to the 16 times earnings range, or closer to the average price/earnings multiple over the past 25 years.

 

Although many multinational corporations already pay well below the 35% tax rate because they are able to take advantage of loopholes, more domestically focused companies should receive a much bigger boost. Specifically, retailers typically receive most of their revenue and profits domestically and also bear the full brunt of U.S. corporate income taxes. Retailers look to be the biggest beneficiary of tax cuts, and they can use the savings to reduce prices and become more competitive with online retailers, or they can let the windfall flow through to profits.

 

Other businesses that are heavily domestic, including telecom service companies and utilities, should also benefit from a change in depreciation meant to encourage investment in capital equipment. The incentive to invest in capital equipment could also have some longer-term economic benefit, as it increases worker productivity as the labor supply becomes constrained. Companies that have a higher percentage of international sales also stand to benefit from the ability to bring back profits at a lower tax rate. In particular, companies in the pharmaceuticals and technology industries that generate significant cash surpluses can bring cash back and repurchase shares, ultimately increasing earnings per share on a lower share count. Small companies also have a more domestic focus and higher tax rate, and they will also benefit from the lower tax rate. Goldman Sachs estimates an additional 0.3% of Gross Domestic Product (GDP) growth as money is injected into the economy.

 

Beyond 2018, any benefit to stock prices and economic growth is harder to gauge. With tax revenue falling and government spending slated to increase, the federal government is providing fiscal stimulus to the economy. At this late stage of the economic cycle, the government would typically run a budget surplus in order to manage growth and build reserves to stimulate the economy during an economic downturn. The federal government may now be more reluctant to cut taxes again in a recession given the additional deficit and evidence that fiscal stimulus is less effective with high levels of debt. This is the opposite of current Federal Reserve policy, which is in a tightening stage. If the Federal Reserve decided to cut interest rates at this point in the economic cycle, it would drive growth over the short term but also increase inflationary pressures and leave the Federal Reserve with little ability to stimulate the economy during the next recession. This is essentially what the federal government is doing. Moreover, the Federal Reserve may be in a position to more aggressively increase interest rates in order to offset this unusual fiscal policy move. The other long-term risk from tax cuts is the impact on federal debt. Research points to slowing growth potential for economies that reach a debt level equal to annual GDP. The current level of debt is about 80% of GDP, which was expected to rise to 90% of GDP by 2027 before taking into account the additional estimated $1.5 trillion in debt created by the tax cut.

 

The circumstances surrounding the current tax cuts are far different than the last major round of tax code changes in 1981, although some may try to draw comparisons. Most important, the country was coming out of a bad recession in 1981 with unemployment at 10% and significant excess manufacturing capacity. Federal debt in 1981 was about $800 billion, or 30% of GDP, compared to 80% of GDP today. By the end of the decade, the federal debt reached $2.4 billion as an additional $1.6 billion had been injected into the economy, taking unemployment to 5% and GDP growth into the 4% range. Although tax receipts rose over the decade, they did not keep pace with inflation or spending, which rose much faster. The 1981 package also received overwhelming bipartisan support, easily clearing the Democrat-controlled House of Representatives and the Republican-controlled Senate.

 

OUTLOOK

 

Although stocks continue to look expensive relative to historic levels, there is no indication of a recession over the near term, and the strong economy should continue to provide support to stocks for another year. Growth in 2018 looks likely to come in at about 2.5% measured by GDP, which many economists believe will be the peak growth rate of our current expansion. Although 2018 may be a year of slower economic growth, economists still expect another year of above average growth. Risks of a recession from the business cycle peaking have increased mainly due to a tightening labor market; however, it would still take time for a recession to materialize even if indicators started flashing warning signals today. It is also not unusual for stocks to remain at the high end of valuations for an extended period of time during a bull market. As we previously mentioned, the best years for stocks often come over the last two years of a bull market and annual returns over 20% are not unusual.

 

Inflation and interest rates are the greatest risks to the current expansion as these are usually what ultimately ends a business cycle. To date, there has been very limited evidence of wage pressure pushing up inflation, leading some people to believe that current demographics have changed the relationship between employment and wage growth. Overall wages only increased by around 2.5% during 2017. This national number may be misleading, however, as metro areas with low unemployment (below 3%) are seeing wages grow at double the national rate. This could be an indication that national wage growth rates may accelerate as unemployment continues to fall, which it most certainly should do during 2018. Another indication of rising inflation is the increase in input prices measured by the Producer Price Index (PPI), which has reached its highest levels in several years. There is a belief that capacity constraints are putting pressure on the supply chain and causing wholesale prices to rise. The Federal Reserve is expected to raise short-term interest rates three times during 2018, but a surprise increase in inflation could increase this number. More aggressive interest rate hikes would not be enough to put the economy into recession this year but could raise investor concerns and increase volatility later in the year. The recent spike in 10-year Treasury bond yields, the most widely watched indicator of long-term interest rates, has stirred some concerns of a rapid increase in rates. We still view a rapid increase as unlikely, and we expect a gradual move upwards throughout the year.

 

Other recessionary risks include deflating asset bubbles or extraneous threats. Stock market bubbles in 1929 and 2000 led to collapses in spending and to recessions. Although stocks are expensive, they are nowhere near levels from 2000, when large technology companies sold at upwards of 100 times earnings. Cryptocurrencies such as Bitcoin are likely in a bubble, but they are not held widely enough that a collapse should have a meaningful impact on consumer or business spending. There are always risks that an external threat could damage the economy, such as the global financial crisis did in 2008, well before the business cycle would otherwise run its course.

 

It is impossible to consider all other risks, but trade issues and China are the most obvious risks looking forward. As a candidate, Donald Trump’s campaign was filled with anti-trade rhetoric. We haven’t seen much action on trade yet; however, there is speculation that the president could draw more of a hard line against trade during 2018. Recent reports that the U.S. could leave the North American Free Trade Agreement (NAFTA) may spook the market leading up to the next round of negotiations in Montreal on January 23 to 28. An announcement that the U.S. was leaving NAFTA would likely lead to increased volatility in stocks and perhaps end the unusually long stretch without a meaningful pullback in prices. If this were to happen, however, the notice for leaving NAFTA is six months, which could give Congress time to intervene and remain in the trade pact before significant economic damage is done. Another risk to monitor is China. In 2016 China showed signs of a slowing economy, driving global economic fears late in the year. Intervention by the Chinese government helped stabilize the data and maintain growth in 2017. With its national economy under control, the Chinese government will likely pull back and continue with economic reforms that could again raise growth concerns.

 

COMMUNICATIONS FROM HC FINANCIAL ADVISORS, INC.

 

We are required by the SEC to offer a copy of our updated ADV Part 2 on an annual basis. By the end of April, we will send a summary of material changes to last year’s filing. You may request a full copy of the ADV Part 2 at that time. The information in both Part 1 and Part 2 for the ADV is also available online at the SEC website, www.adviserinfo.sec.gov. Please call us if you have any questions or concerns.

 

Stephen C. Biggs, CFP®, CFA

 

January 19, 2018