A strong fourth quarter closed out a remarkably good year for stocks. The S&P 500 rose every single month for the year—a first in the history of the index. The S&P 500’s 21.8% return outpaced solid returns in small- and mid-cap stocks with the Russell 2000 Small-Cap Index up 14.7% and the Russell Mid-Cap Index up 18.5%.
Foreign stocks had an even better year as foreign currencies strengthened relative to the US dollar. The MSCI All-Country World Index excluding the US rose 27.8%. Foreign markets face less uncertainty today than a year ago as potentially disruptive elections in France, Netherlands, Germany, and Japan largely resulted in votes for the status quo.
It’s all about taxes
President Trump signed his much-promised tax bill into law before Christmas. The new law reduced the corporate tax rate from 35% to 21%. With the new bill in place, Factset is projecting S&P 500 earnings will grow by 11.8% in 2018. That would come on the heels of an estimated 9.6% growth in S&P 500 earnings in 2017. Given the strong performance of the market in 2017, it appears 2018 earnings growth may already be baked into today’s market prices. Capital Group, which manages the American Funds, estimates that the tax cut could also lead to the repatriation of $1.5 trillion in corporate cash that heretofore has been held offshore.
If the tax cuts can stimulate economic growth as expected, inflation may pick up, forcing the Federal Reserve to reconsider the current path. Right now, the Fed is expected to raise rates by 0.25% three or four times in 2018. The Fed, however, will soon be under new management as the top three positions are about to be filled with new people. Chairwoman Janet Yellen will be replaced by Jerome Powell on February 3rd. Replacements for Vice Chairman Stanley Fischer and New York Fed Chief William Dudley have yet to be named. We assume the new Fed will operate much the same but it is hard to know for sure right now.
Late stages of the business cycle
As we look ahead to 2018, it appears that the economy still has some room to run, but a case can be made that we are in the later stages of the business cycle. Late in the business cycle, we typically see the Fed raising short-term interest rates. Usually the Fed raises rates to manage accelerating inflation but that isn’t the case this time around as core inflation has been just 1.7% over the last two months leading up to December. The Fed instead has been doing so to return to a more normal monetary policy in order to have arrows in the quiver for when the next recession does hit.
Long-term Treasury yields actually fell in 2017 as short-term rates rose. Stocks have actually done quite well historically when 10-year Treasury yields were less than half a percent more than 2-year yields. We ended 2017 with the 10-year yielding 2.40% and the 2-year at 1.89%, so they are almost into that sweet spot. The tricky part is that every single recession over the past 50 years has been preceded by 10-year Treasury yields falling below 2-year yields. The narrowing of the spread we are currently seeing usually happens late in the business cycle but it can persist for multiple years while the bull market rolls on, so it isn’t a great indicator of how close we are to the top.
Something else usually seen late in the business cycle is widespread optimism. There’s definitely no shortage of optimism for Bitcoin but the cryptocurrency isn’t large enough yet to be a major risk to the global financial system. While it is debatable whether or not stocks have run too far and are overvalued, we lean slightly towards the overvalued side in our opinion as you see in Benton’s commentary.
One way to look at the overvalued debate is to look at the valuations of market leaders relative to historical valuations. For example, many of the “Nifty Fifty” stocks in the ‘60s and ‘70s traded at more than 50 times earnings and during the technology bubble of the late nineties, “dot-com” stocks had astronomical valuations while having little to no earnings or assets.
As of today, the five largest companies in the S&P 500 are the tech giants Apple, Alphabet (Google), Microsoft, Amazon, and Facebook. These five stocks averaged a staggering 46% return in 2017 and added over $1 trillion in market cap. By comparison, the next five largest companies (Berkshire Hathaway, Johnson & Johnson, JPMorgan, Exxon Mobil, and Bank of America) averaged a 21% return and added just over $300 billion in market cap.
Although optimism appears overly high, immediate downside risk is moderated by the fact that consumer and business debt levels are relatively low due to years of deleveraging following the financial crisis. Since 2012, US consumers have been and still are spending less of their after-tax income on debt payments than at any other point since 1980. US businesses are in a similar position. US non-financial companies’ cash holdings were expected to rise to $1.9 trillion in the fourth quarter of 2017 according to Moody’s. That’s over 10% of our 2016 GDP.
With Washington providing the new tax bill, regulation reform, and potential new infrastructure spending, we could see consumers and businesses having even more cash available over the next couple years. What percentage of that is spent will be a big factor for how fast and for how long this nine-year bull market can continue to run. 2017’s strong gains, however, will be a tough act to follow in 2018.