Buckle Up, Some Turbulence Before Clear Skies
"A good conscience is a continual Christmas."
- Benjamin Franklin
As year-end approaches, market watchers are focused on the Fed FOMC Meeting, Tax bill amendments, potential budget stalemate, Bitcoin futures, and a grand parade of 2018 forecasts. All these short-term issues appear to make a Santa Claus Rally unlikely but remember, it's Santa. Markets were off in 1Q2014 and 1Q2015, but rallied in 2016 after the election. Many bears are playing out a similar scenario as seen in 2014-2015 for market weakness early in 2018 as markets sell off and the economy slows. All because of a flattening yield curve and unknown Fed policy. In fact, with the exception of a brief selloff from August 2016 into the election, the major averages have been straight up without any broad-based correction. As discussed on these pages for the past few years, it has been the underlying strength of the economy that has accompanied stocks higher even though earnings, primarily Energy sector losses, were flat to down marginally over much of the 2014-2015 period. Longer-term, from January 1,2012 through December 31,2016 the S&P 500 rose 94% while total S&P 500 earnings were up only 20%. Over this period astute stock investors saw progress in the transition to a more normal business cycle and understood the weakness was external; Europe, oil, and China.
Corrections can happen any time and for almost any reason. But there has never been a bear market when Developed and Emerging country growth is steadily rising, oil is up well-above recession levels and China is improving faster than even the most optimistic outlooks. Contrary to the negative headlines, the Fed remains accommodative and even without fiscal stimulus, other than reduced regulation, the economy, measured by GDP, is up over 3% for two consecutive quarters and is forecast above that level for 4Q2017. Inflation and interest rates remain low with an overanalyzed flattening of the yield curve. Presidential politics is just that and as long as the short-term distractions do not tilt the economy to slower growth, markets will not experience a 10% correction.
The current uncertainty in markets has led to a premature rotation out of Technology and into Financials and Consumer Staples. The potential of rising interest rates and the reworking of Dodd-Frank are contributing to the shift for banks. Staples are investments in a safe sector, particularly with a spending consumer, a retail rally off recession levels, and potential corporate tax reform. Technology, the performance leader is the least positively affected sector by the best guessed resulting Tax bill. According to Ned Davis Research, technology companies pay on average 21% in corporate taxes. The Table shows selected Sector effective tax rates. Clearly Technology and Healthcare have the least to gain from a reduction in the tax rate as it is currently structured. Interestingly, these are two of the higher performing sectors since the start of 2017. Other aspects of the plan favor Technology, such as the 100% immediate write-down, and the potential for a workable repatriation of overseas funds. Given the earnings outlook, demographics emerging market growth, the outlook for Technology remains positive for the longer-term.
The addition of a late amendment in the Senate-passed bill includes an Alternative Minimum Tax (AMT) for corporations at a full 20% rate. (It was expected to be repealed for corporations.) The unintended consequences of the AMT will be to nullify the R&D tax credit which directly benefits Technology, Healthcare and the Industrial sectors. Additionally, the Repatriation Tax on accumulated retained foreign cash earnings is 14.5% in the Senate version and 14% in the House bill. This is well-above the 10% initially proposed. Technology companies hold nearly two-thirds of the estimated $2.5 in foreign funds. S&P 500 technology companies account for $950 billion, according to Goldman Sachs. Four companies, Apple ($261.5 billion), Microsoft ($133.0 billion), Cisco ($70.5 billion) and Oracle ($54.4 billion), hold over 50% of that total. With the tax holiday rate much higher than anticipated, it will no doubt result in lower repatriation and limit the positive affect on corporations, particularly tech companies.
We expect the tax reform to be more favorable for corporations than individuals but because of fiscal restraints, phase-in and phase-outs, and in an effort to firm up vote count, acquiescing to individual GOP Senators. The bill will pass but in a much more moderate version because of the compromises. The weakened bill will attract attention as bears flaunt its inability to stimulate growth. Readers of the Compass are aware of our belief that except for earnings and stock prices, the economic value to the Tax bill, particularly for individuals, is limited. However, in retrospect it will be concluded that at this stage of the economic cycle, it was a positive on balance and did no real damage. Our hope is that we can move forward beyond the politics of unnecessarily satisfying campaign promises. The continued growth to the economy is already back loaded particularly for Housing and Capex, but the Tax bill will get credit. That's life in the Swamp.
One of the more recent discussions of the movement among the various sectors in the market questions the role of ETF's and low market volatility. In an analysis published in Seeking Alpha titled "The Black Hole: How passive investing became the new QE," investing with the belief that passive flows (ETF's) are distorting markets by creating self-fulfilling price appreciation. It assumes active management holds large positions in top performers, i.e. FAAMG (Facebook, Amazon, Apple, Microsoft and Google) and sit back as Passive Funds are forced to purchase the underlying stocks. By not selling, the Report claims the creation of a "Perpetual Motion Machine." It also creates a new breed of investment, "Smart-Beta Funds," which hold a small number of these Large Cap companies. Of course firms such as Goldman, disagree as they parcel funds to these investments. Wells Fargo suggest that buy side money managers have decided to be overweight in Technology with the best strategy to hold since over the past couple of years, they have no doubt regretted selling these shares. By not selling they participate in the Perpetual Motion Machine.
Most recently, 25% of passive investing dollars went to tech purchases, up from 20% at the beginning of the year. In today's market where upwards of 70% of volume is computer generated, it is not too hard to envision these "Quant traders," with a time horizon of minutes to days, throwing a monkey wrench in the Perpetual Motion Machine. For whatever reason, valid or not, when selling occurs algorithmic traders will move first, leaving active managers to cope with the damage. Computer-generated trades lack fundamental reasons for buying and selling and can result in whip-sawed active managers holding these stocks in contradiction to their stated strategy. An example of possible potential breakdown of the Perpetual Motion Strategy occurred in the Biotech sector beginning in July 2015. After the IBD reached its high at $133, the ETF fell rapidly back below $100 only to reverse up to $115 and then selling off into the mid-$80's. At that time there were clear indications that the volatility on the underlying stocks was a result of satisfying positions of Passive Funds. (Portfolios at Hutchens Investment Management are not and never have been participants in the Perpetual Motion Machine Strategy.)
Our investment policy remains optimistic. Despite the recent selloff, our view does not assume a meaningful decline resulting in a market correction of 10% or more. Over the past two months, more than 1/3 of listed companies have had a 10%+ correction, led by Energy, Retail and Technology sectors. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderation in rate increases, and strong consumer confidence. We expect the economy to grow at a 2% annual rate for 2017, but data for wages, housing and Internet retail will continue to improve as the consumer remains healthy and willing to spend. At this time it is unlikely given the strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary US policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap Consumer Discretionary, Technology and Industrial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.