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Market Commentary — 4th Quarter 2017
The fourth quarter marked the end of a year that produced very strong equity returns. Increased optimism regarding economic growth and corporate earnings drove domestic equity indices to new all-time highs as we approached the end of 2017. Despite concerns that equity valuations were approaching “bubble levels,” we witnessed the strongest returns of the year during the fourth quarter. The S&P 500 gained 6.6%, while the Dow Jones gained 11% during the quarter, and the Russell 2000 inched up by only 3.3%. For the year, the S&P 500 gained 22.8%, the best performance since 2013. Meanwhile, large-capitalization stocks soundly outperformed their smaller counterparts throughout the year as the Dow Jones gained 28.1%, while the Russell 2000 only improved by 14.6%. This was at least partially due to the increased proliferation of ETFs, which tend to focus on investing in the larger companies in a particular index or sector.
Highlighting the fourth quarter was the corporate and personal income tax reform bill that was passed into law just before year-end. This came against a backdrop of previous GOP legislative blunders and an apparent lack of leadership from within the party. As late as October, most analysts believed that no tax legislation would successfully pass in 2017, and many were beginning to think that tax reform would go the same way as the GOP’s vow to repeal Obamacare. In the end, however, the party was able to unify and pass what we believe to be a strong, pro-growth tax package. From our perspective, the key piece of the reform that will most directly impact equity valuations is the reduction of the top marginal corporate tax rate from 35% to 21%. In our opinion, this will help drive increased corporate investment, robust economic growth, and increased corporate earnings.
On the personal tax side of things, we see a little more of a mixed bag. While the new tax plan definitely simplifies the code, it is not clear to us whether this will lead to changes in spending that will spur growth. On the positive, most employees will see a jump in their after-tax income beginning in February, which we expect would lead to increased consumer confidence and consumer spending. On the other hand, many people living in states with high state tax rates and/or high real estate values such as California, New Jersey, and Connecticut, will see much, if not all of these gains washed away at year-end due to the restrictions placed on the deduction of state and local income tax as well as mortgage interest.
On the personal tax side of things, we see a little more of a mixed bag. While the new tax plan definitely simplifies the code, it is not clear to us whether this will lead to changes in spending that will spur growth. On the positive, most employees will see a jump in their after-tax income beginning in February, which we expect would lead to increased consumer confidence and consumer spending. On the other hand, many people living in states with high state tax rates and/or high real estate values such as California, New Jersey, and Connecticut, will see much, if not all of these gains washed away at year-end due to the restrictions placed on the deduction of state and local income tax as well as mortgage interest. As a result, it seems unclear which of these two opposing forces will have a greater impact on the economy. We were, however, encouraged to see the multitude of corporations such as AT&T, Walmart, and Apple that gave out either hourly raises or one-time bonuses to a wide swath of their employees as a direct result of the change in tax laws. This combined with the decreased withholding taxes will mark the first significant middle class wage increase since 2008.
Despite the current bull market’s length of almost eight years, the set-up for 2018 remains robust. One of the campaign promises of the Trump Administration was to eliminate two regulations for every law that was passed. Through the first year of his administrations, this goal has been achieved. This unleashed “animal spirits,” and helped propel equities to several all-time highs in 2017. The tax cuts are likely to lead to another leg up in equity markets. By dropping the marginal rate from 35% to 21%, analysts almost immediately increased 2018 earnings estimates by 10%. Secondary effects of the cut, however, have yet to be priced into the market in our opinion. These initiatives, which include repatriation of funds from overseas, as well as increased investment and capital expenditure as a result of the lower after-tax hurdle rate, and the potential for increased consumer spending, are likely to boost economic growth beyond current expectations.
Moreover, the possibility of passing an infrastructure bill as part of the current budget negotiations remains high despite press reports to the contrary. Given the partisanship in Washington and the looming deadline to pass a budget, we would not be surprised to see another Government shutdown before the budget is passed. Nevertheless, we expect to see a final budget passed over the next few months that allocates a significant amount towards infrastructure repair and upgrades as well as funds to rebuild areas ravaged by the hurricanes and other natural disasters. If passed, this would lead to many high-paying jobs that would further bolster our economic growth forecasts as well as our outlook for wage growth and economic spending.
As you can probably surmise from the tone of this letter, we continue to have a bullish bias toward the equity market. We understand that valuations are above average, but we do not believe that we are anywhere near the “bubble” valuations we witnessed at the turn of the century. This is especially true given our view that economic growth is likely to exceed expectations for at least the medium-term. With the markets already up over 5% in the new year, we would not be surprised to see a 3-6% correction at some point, but this would likely be a buying opportunity, not the end of the bull market. As we have stated in past letters, valuation alone is rarely enough to change market sentiment.
The major risk to our bullish thesis, outside the generally unpredictable geopolitical event, continues to be rising interest rates and the prospect of increased inflationary expectations. During the fourth quarter and into the new year, interest rates on government debt have risen to levels not seen in several years, but at this point the increase has been attributed to economic growth rather than inflationary fears and are still at historically low levels. Our major concern is that as the economy heats up, inflationary pressures will grow and drive interest rates significantly higher, which would likely lead to a meaningful reduction in equity valuations. For several reasons, the main one being that the proliferation of the internet has dramatically reduced pricing power across most industries, we believe that this scenario is a low probability event.
Doheny Asset Management oversees assets for a variety of private clients, foundations, endowments and pension plans. We offer balanced, equity and fixed income strategies and provide each client with a superior level of administrative support and client service.
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Market Commentary by Quarter
Our perspective on the markets and the issues affecting the economy over the past year.
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