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4th Quarter 2017 Market Commentary

Stocks around the world posted double digit returns in 2017. On the heels of a healthy 2016, the current bull market trudged along triumphantly. In a Goldilocks scenario, volatility was conspicuously absent from the markets. There were only four days that the S&P 500 Index declined more than 1%, with the largest drawdown of 1.82% occurring on May 17th. Emerging markets saw the strongest returns with the MSCI Emerging Markets Index up 37.28% for the year. No, that’s not a typo.

Bond returns were more muted with the Barclays US Aggregate Bond Index finishing the year up 3.54%. International and emerging market bonds also outpaced returns on domestic bonds, aided by a weaker US dollar. Short-term interest rates continued to rise, while long-term rates held steady. The 2 Year Treasury began the year at 1.20% and finished at 1.89% while the 10-Year Treasury barely budged from 2.45% to 2.40%. Oil seemed to break out of the $45 – $55 range it has traded in since mid 2016. West Texas Intermediate (WTI) finished the year at $60.46 per barrel.

Tax Overhaul

On December 22, President Trump signed into law the Tax Cut and Jobs Act of 2017. While the law makes many tweaks to individual taxes, the major changes affect US corporations. The maximum corporate tax rate of 35% drops to a flat rate of 21%. This is combined with the elimination of the alternative minimum tax (AMT) for corporations. Sadly, the AMT elimination for individuals was scrapped in conference negotiations, but the threshold for qualifying for AMT jumps to $500,000 for individuals and $1,000,000 for married couples.[1] In addition to lowering the corporate tax rate, the law allows corporations to bring back cash from overseas and pay a one-time 15.5% repatriation tax rate. This could be a potential boon for the tech industry, as Apple, Microsoft, Cisco Systems, and Google (Alphabet) have $483 billion in cash parked overseas.[2]

Most investors speculate that smaller companies, that conduct most of their business domestically, will benefit the most from the tax changes. However, companies carrying deferred tax assets on their balance sheet will have to recognize a reduction in value of that asset. Further, limits to the deductibility of interest could hinder companies with large amounts of debt.[3] Corporations lauded the changes, with many well-known names announcing one-time bonuses, minimum wage hikes, or increased 401(k) matching for their employees. More time is needed to digest the final implications of the tax changes. Companies reporting year-end earnings will offer the next clues.

Market Valuations

Since the low in March 2009, the S&P 500 Index is up over 430% on a cumulative, total return basis. Investors seem nervous that the market is being overvalued. There are many metrics for attempting to quantify whether or not the market is over or undervalued. Each metric has its merits and each has its flaws. The forward price-earnings (P/E) ratio of the S&P 500 Index is 18.2 times earnings. This is higher than the 25-year average of 16.0 times earnings but below the 1999 peak of more than 24 times earnings. The Shiller price-earnings ratio (CAPE) is currently 32.4, well above the 25-year average of 26.4. The price-to-book ratio (P/B), a more stable valuation measure, is currently 3.1 for the S&P 500 Index versus a 25-year average of 2.9.[4] By all measures, the market value is higher than historical average but not approaching any records.

One crucial factor in considering price-earnings ratios is the denominator, earnings. Third quarter 2017 earnings for the S&P 500 Index were $31.32 per share, an all-time record.[5] Consensus analyst estimates call for the next four quarters of earnings to break this record. If earnings are growing, future projections for PE ratios may not be as rich as predicted. While short-term distractions such as politics, geopolitical tensions, commodity booms and busts, natural disasters, and war move markets in the short-run, the underlying factor for valuation of stocks is corporate earnings. From this perspective, the growth in the markets seems reasonable.

The S&P 500 Index has reached 188 new all-time highs since March 2013. There were 61 new all-time highs in 2017 alone. This statistic tends to make investors nervous. However, historically the stock market has made many new highs to get to today. Try to remember your experience investing during the 1980’s and 90’s. Dare we hope to be in the midst of a similar experience?

Bitcoin

Cryptocurrencies and Bitcoin dominated the financial news cycle when the price of one Bitcoin turned parabolic and climbed to more than $19,000. Let me preface this segment by saying that we have no expertise in cryptocurrencies and understand them only slightly better than the average person. However, the topic is now commonly broached in our client meetings and conversations. What we know is that the technology underlying cryptocurrencies, known as blockchain, could lead to extraordinary advances in the ease of transacting in financial markets. This has led large financial firms such as Fidelity Investments and Goldman Sachs to invest in research for the application of blockchain in financial transactions.

Before you are tempted to download the Coinbase app and start trading Bitcoin, Ethereum, or Litecoin, consider that these instruments lack some of the most basic protections to be considered “investments”. For example, there is no method of custody for cryptocurrencies. A custodian is a financial institution that holds investment assets in safe keeping and communicates the value of your holdings via regular statements. Further, the IRS issued guidance in March 2014, that cryptocurrencies are considered property and subject to taxation when received as income or as a result of a capital gain or loss. However, with no custodian to issue the appropriate tax reporting, investors have no mechanism to prove their cost basis if audited by the IRS. If you want to take a deep dive into the abyss of cryptocurrencies, Patrick O’Shaughnessy interviewed some of the leaders in the field over three episodes of a podcast titled Hash Power.

Everyone’s favorite investor Warren Buffett recently weighed in on the Bitcoin craze saying; “In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending.” Bitcoin is already down almost 40% from its December peak. It’s likely there will be many booms and busts as this technology, currency, dare we say “asset class” approaches maturity.

Fear and Greed

Despite all the statistics and fancy analysis we have today, the markets are a derivative of human emotion. Numerous studies prove that humans fail to act on logic and reason when money is involved in the decision making; especially if losing money is a possibility. There’s a great book detailing the history of market hysteria and bubbles beginning with the Tulip Mania in Holland in the 17th century. Extraordinary Popular Delusions and the Madness of Crowds is a fascinating but dense study of human greed and the “fear of missing out”. I suspect there’s a little of this happening with Bitcoin lately. In hindsight, there are always extraordinary investment options that could have been life changing. One of my favorites is holding Apple stock since it became public in 1980. But is there even one investor who managed to own it for the entire time-period? Everything looks easy in hindsight. Investors should keep their heads down, follow a disciplined strategy, rebalance periodically, and let time pass.

Remember these two? Tweedledum and Tweedledee are a great analogy for fear and greed. Both emotions are equally dangerous for investors.

 

January 2018

 

Footnotes:

[1] Kitces, M. “Individual Tax Planning Under the Tax Cuts and Jobs Act of 2017”. December, 18, 2017. https://www.kitces.com/blog/final-gop-tax-plan-summary-tcja-2017-individual-tax-brackets-pass-through-strategies/

[2] Meisler, L. “The 50 Largest Stashes of Cash Companies Keep Overseas”. June, 13, 2017. https://www.bloomberg.com/graphics/2017-overseas-profits/

[3] Blomberg BNA, Tax Reform Watch; https://www.bna.com/2017-corporate-tax/

[4] JPMorgan Q1 2018: Guide to the Markets, slide 5, https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets

[5] JPMorgan Q1 2018: Guide to the Markets, slide 7, https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets

Disclosures:

  • All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. It should not be regarded as a complete analysis of the subjects discussed.
  • Information presented does not involve the rendering of personalized investment advice and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Tax information is general in nature and should not be viewed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
  • Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio. All investment strategies have the potential for profit or loss. There are no guarantees that an investor’s portfolio will match or outperform any particular benchmark. Index returns do not represent the performance of ThirtyNorth Investments, LLC, or its advisory clients.
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