Second Quarter 2018 Newsletter
Just Thinking Again
After a volatile start to the year, highlighted by the parabolic early rise and followed by an event driven decline, the S&P 500 managed to show a total return of 3.43% for the first six months. Three cheers for the market! In addition the Atlanta Fed’s forecast for the second quarter is 4%, employment has continued to increase, and expectations are that corporate profits will be strong this quarter due to the corporate tax cut. With the increase in S&P 500 profits the market PE has dropped to a much more reasonable level of 17 times earnings. It sure looks like the sharks are gone, and it’s safe to go into the water again.
Looking behind the headlines we can see a different picture. The S&P performance was the result of the FAANG (Facebook, Apple, Amazon, Netflix, and Google) stocks’ performance. The rest of the S&P returned a negative 0.73% according to a study by Merrill Lynch. So, despite the averages you could have just as easily had negative performance for the first half of the year if you didn’t own the few glamour stocks. The DJIA returned a meager 1.26% for the first six months. This is not the kind of performance you would normally expect based on the quarter’s economic results.
What is wrong? Maybe it is a combination of central banks’ interest rate increases, domestic and international debt levels, and a decreasing liquidity from the our Fed’s steps to shrink its balance sheet. The huge growth in our monetary base after the 2008 market collapse and the additional stimulation of near zero interest rates is being withdrawn. It is logical to assume that reversing the stimulus will also turn the positive results to date into negative performance for stocks and bonds despite the short term stimulative effect of the new tax package. The bond market is showing concerning indicators as short term rates are being increased by the Fed yet longer term rates are flat or declining. If short term rates exceed longer term rates the result is called an inverted yield curve and is considered to be an early indicator of a recession and a poor stock market. One reason this causes a business slowdown is that banks do not like to lend long term at lower rates than it costs them for the funds, so credit dries up and businesses can’t grow without access to credit. A yield inversion generally precedes a recession by a year but the market is understood to anticipate economic events by six months, so we should see pressure on the market prior to a recession actually taking place.
Some pundits are seeing an indicator in the bond market that they claim is more significant than the potential yield inversion. They look at the spread, or difference, between the yield on treasury bonds and corporate bonds of the same maturity. If this difference widens, as it is currently, it is seen as an indicator that corporations will have poorer results going forward and are therefore riskier by definition. A big spread is the standard in the junk bond market but is starting to occur in the investment quality segment of the market as well.
The overarching potential for a market retrenchment is the deceleration in money supply liquidity as the major central banks around the world are engaged in significant contraction of their money supply growth rates. This decline in liquidity and the increasing debt around the world is likely to put a damper on future economic growth. Where it used to be that $1 of debt would provide an additional $1 of GDP, it now takes $3 of debt to achieve the same result. The new tax law should create the need for significant new debt in the early years to offset revenue reductions, particularly in the corporate area. The increased cost of carrying this and other short term debt needing to be rolled over will definitely put a damper on the economy as rates increase due to the Fed’s current policy. In spite of all these concerns, this crazy market might just have a blow-off rally before the sobering hangover begins. If it should happen, you don’t want to be the last person to leave the party.
In closing I have a couple of comments about the new tax act.
· It would be a good idea to have your tax accountant preview your 2018 return to see how you will fare under the new law compared to your 2017 return.
· Make sure your new reduced federal tax withholdings and/or estimated payments will be sufficient to meet your requirements to avoid penalties for under withholding.
· If you benefit from the new standard deductions look to strategies to benefit from your charitable contributions, such as bundling them every other year or establishing donor advised account.
· Be sure to review the impact of state income and local real estate tax limitations when considering a second home, unless you are buying it for rental purposes.
Most individuals will not make any changes to their tax driven behavior until after they see their 2018 return. Beat them to the punch and make changes early if you can benefit from doing so.
Robert B. Needham, CFA July 18, 2018