December 6, 2017

Normally, December is a good month for stocks, especially at the end of a strong year. But you wouldn’t know it from the market’s behavior the last few days. Volatility has picked up amid wild intraday swings and stocks have generally closed at their daily lows, not a good sign. In particular, the year’s winners, notably the technology stocks have been taking a beating, while the more prosaic consumer staples and the retailers who were the year’s single worst performing group, have had a solid performance. Not to be ignored, the financials have also had a strong few weeks. It isn’t a coincidence that many of the strongest stocks over the past few weeks have been companies that will be the biggest beneficiary of tax reform.

Let me start by looking ahead to 2018 and then back up and comment briefly on tax reform itself. As you have heard me say often, stocks are about earnings, interest rates and the dollar, probably in that order. Earnings were in their own recession between late 2014 and early 2016 in reaction to slower growth overseas and a strong dollar that translated weakened foreign earnings back into even fewer dollars. But after the market euphoria of a Trump victory wore off early this year, economic growth began to accelerate a bit, the dollar weakened notably and earnings overseas started to rise quickly. As a result, earnings in 2017 consistently beat expectations. The dollar weakened throughout most of the first three quarters to the surprise of many analysts as growth overseas, in part in response to central bank easing in Europe, Japan and China, accelerated. Finally, all this growth was achieved without any substantive change in interest rates, another surprise. Thus, three surprises, better than expected earnings, lower than expected interest rates, and a weaker dollar all worked in unison to lift stock prices around the world. In the U.S., the S&P had risen about 20% until the pullback of the last two days.

It is important to note that the success of the market is more a function of the three coinciding positive surprises than to the absolute level of earnings, interest rates and the dollar. Markets always price in expectations. Performance is highly correlated to how markets perform versus those expectations.

For the moment, I am going to assume that Congress presents Mr. Trump a bill to sign on or before December 22 that reforms the tax code in a manner consistent with a composite of the bills passed by the House and Senate. Most observers give that a 90%+ chance of happening. Only death and taxes are 100% certain. Thus, while it may take analysts a while to fully factor in tax changes into their 2018 earnings forecasts, markets, always efficient, will adjust for the tax changes immediately. As a result, come January 1, 2018, the obvious direct impact of a new tax law will already be reflected in stock prices. So will a continuation of pretax earnings growth of close to 10%. That leaves the dollar and interest rates to consider.

If I presume U.S. economic growth is 2.5%, plus or minus, that should approximate the growth rates of the rest of the developed world. If that is a correct assumption, the dollar should be relatively stable, i.e. it should stay within a 5% band against key currencies throughout the year. I am not a currency guru. I view currencies as the balancing mechanism between weak and strong economies. Lately, economies have been growing in unison, and currencies have been relatively stable. I don’t see anything that is likely to break that trend any time soon.

That leaves long term interest rates.

Here’s the case for rates staying near current levels. Inflation hasn’t budged since the Great Recession. While we are inching closer to full employment, the year-over-year wage growth figures that accompany the monthly employment report have changed little in recent months. The next report comes out Friday morning. The Internet continues to exert deflationary forces by providing better pricing information to the buyer. As the Internet gets more pervasive and more efficient, those pressures continue. Soon you will go to a car dealer, scan the invoice pricing sheet on the car window and instantly find alternative prices anywhere in a 50-mile radius. We are close to that now. The Internet related efficiencies, the remaining numbers of part-time workers willing to work full time, and excess manufacturing capacity all continue to keep inflation muted. Assuming those trends continue, 10-year yields can stay close to the current 2.4%.

But now let me offer the case for higher rates. Tax reform and natural economic growth are moving us close to what economists call potential GDP. All the shortages are getting used up. Trying to speed up an economy already operating at its potential will create disjointments. One of those will be higher inflation. Let us assume inflation rises to 2.0-2.5% this year with wages pushing up about 3%. Let us further presume that GDP growth is closer to 3% than 2.5%. I could use a higher number, but frankly, without a major change in productivity, that isn’t likely to happen. Still 3% real growth and 2% inflation means nominal GDP can grow 5%. Normally, long term (30-year) interest rates match pretty closely the rate of nominal growth. That suggests a 10-year yield of 4%.

There is a big difference between 4% and 2.4%. No one that I read is forecasting 4%, but economists rarely want to stray too far from consensus. Perhaps the best analogy I can offer is 1994 when rates spiked as the economy grew. Stocks churned violently, but ended the year about where they started, while bond prices fell sharply and bond investors had negative absolute returns. Note that once the adjustment ended, stocks went on a tear for the next 4+ years before the Internet bubble burst in 2000.

Without predicting a 4% 10-year Treasury yield but supposing rates do move higher, that would suggest a contraction in P/E multiples. By extension, that also suggests that value stocks, which significantly underperformed growth stocks in 2017, should do relatively, if not absolutely, better.

One of my constant principles of investing is that you buy stocks for offense and bonds for defense. Obviously, if rates were to rise sharply, you don’t want to buy long duration bonds. As for stocks, earnings growth still matters. In a period of rising interest rates and falling P/Es, companies with no earnings growth will sell at lower prices. Some growth is necessary. In the short run, where rotation is rapid and stocks move sharply up and down almost daily, the idea of earnings growth driving stock valuation can be lost.

As for the current market, many are fearful of tax-related selling through early January. Some of what is happening today is non-taxable investors selling their winners before taxable investors do the same in early January. But don’t mistake this for an incipient bear market or even a big correction. As long as interest rates remain steady and earnings keep growing, that isn’t going to happen.

We have gone almost two years since a correction of 10%. Everyone is looking for one. But corrections of that size don’t just happen very often for no reason at all. Ignoring the ever present possibility of a geopolitical event, the two factors that could seed a correction are significant changes in the outlook for earnings, and a meaningful short term change in interest rates. With tax reform all but done, it is hard to see how earnings expectations are going to come down any time soon. But, as noted above, a lot of factors could send interest rates sharply higher. It may or may not happen, but if rates suddenly push above 2.6%, a level touched in the February Trump-euphoria induced high, then a meaningful correction could happen.

I promised to end with a discussion of tax reform. Here I am going to take a different tact than what is normally discussed. I believe almost 100% of the time, purely partisan legislation that makes it to law is flawed. It is flawed precisely because opposing sets of eyes with different views have a way of flushing out second derivative errors. I am no political pundit. The House and Senate bills now go to conference. While Republicans will have absolute control of the dialogue and the process, they would be smart to solicit and receive Democratic input. They may choose to ignore 90% or more of what they hear, but even if there are just one or two improvements that can be derived from the conversation, it would be a positive. Obamacare was flawed for the same partisan related reasons. Requiring everyone, young and old, sick and healthy, to buy the same basic policy was a mistake that now creates havoc on the public exchanges.

That moves me to a discussion of the elimination of state and local tax deductions. I understand it generates big income to pay for some of the other benefits. I get the theories on both sides of why eliminating the deductions are good and bad. I am not interested in theory. I know most of the big tax states are Blue states. I get the politics. But now let me get to the reality. California, New York and Illinois are 3 high-tax states. As a consequence, they are the three states with the highest emigration. Those that leave generally are financially better off than those left behind. Those left behind can ill afford to pay higher taxes, but they also require more services and support. Eliminating the deductibility of state and local taxes is going to drive the highest income earners to move away. I am not talking as a liberal or a conservative. All I am doing is laying out the facts. Now let me move to Florida, a state with no income or estate tax. Obviously, some of those leaving New York and Illinois will head there (there are plenty of other states with little or no income tax). But also, Florida is about to receive close to 200,000 refugees from Venezuela and hundreds of thousands from Puerto Rico. If Puerto Rico’s infrastructure can’t be restored soon, that number will swell further.

Perhaps the consequences of these population shifts will end up positive. I don’t know. But it might be worth someone’s time to think about the consequences of what tax reform might do in the next couple of weeks before the bill becomes law. The second derivative consequences are harder to uncover. Some may not be visible at all at the moment. We all know that when tax laws change, they invoke changes in behavior. State and local taxes is simply one example. Congress, of course, can make midcourse adjustments next year and in subsequent years. But accelerating the large population moves already in place doesn’t strike me as good policy, politics aside.

On Wall Street, everyone wants to see this bill pass because lowering corporate tax rates will boost corporate earnings. That’s the easy first derivative response. I am not so sure the cumulative effect of the second derivative responses will be so positive.

NBA star Giannis Antetokounmpo is 23 today. Larry Bowa turns 72.

James M. Meyer, CFA 610-260-2220

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