Anticipation for tax cuts fueled market rally; now what?
Investors bought the rumor. Is time to sell the news?
The reference to that Wall Street maxim explains the tendency of stocks to climb in anticipation of a favorable event — in this case, a business-friendly tax cut — and then plateau or decline after the information has been digested.
Stocks are up about 30% since Donald Trump’s election, in part because interest rates remain low and the U.S. economy seems back on firm footing, 10 years after the start of the Great Recession in December 2007.
But the prime catalyst for recent gains was expectations that a Republican-controlled Congress would pass legislation lowering corporate taxes.
About two-thirds of the windfall from the tax bill’s $1.5 trillion price tag will accrue to businesses, making it the largest such cut since the corporate income tax was introduced in 1894. Notably, the effective and statutory corporate tax rate was about double the new 21% rate during the 1950s and ‘60s, a period often viewed as economic perfection.
For the shareholder class — a group that excludes about half of all Americans — the past 12 months was a nonstop magic carpet ride. Large-capitalization stocks rose about 20%, or roughly double the long-run average and better than 57 of the 92 years since 1926.
More remarkable, however, was the near-total absence of downside volatility. Weeks and months passed without major indexes falling by a single percentage point in a single day, and the VIX index — known as Wall Street’s fear gauge — hovered near historic lows for most of the year.
Simply put, there simply was no reason for stocks to go down. But with the passage of tax legislation, there is one less reason for stocks to go up.
Pedal to the metal
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Only a full-on contrarian might argue that elevated valuations and an aging business cycle are sufficient reasons to sharply reduce exposure to the U.S. equity market. As long as inflation stays low, the Federal Reserve is likely to go slow on normalizing monetary policy, keeping returns on competing asset classes such as cash and bonds relatively unattractive. By the Fed’s preferred metric, inflation has undershot the central bank’s 2% target rate for five-years running.
Since the Fed cut benchmark rates to zero in December 2008, equities have essentially been the only game in town.
Still, the equity market’s dependence on low borrowing costs to justify high valuations also exposes stocks to one of the most likely sources of trouble in 2018: an overheated economy that causes the Fed to tighten faster than expected.
By the standards of the post-war boom in the middle of the 20th century, the current U.S. economic growth rate of around 3% remains modest and probably low enough to keep inflation contained, especially as more workers come off the sidelines.
The nation’s demographic makeup has changed significantly since the 1950s, however, and if the stimulative impact of the tax cuts pushes growth toward 4% in 2018, the threat of inflation will catch the attention of policymakers, even if consumer prices remain stable for a while longer.
But according to Minneapolis Fed President Neel Kashkari, the most dovish member of the Fed’s rate-setting committee, such concerns are overblown.
Kashkari recently told Bloomberg television that, based on interviews with CEOs in his district, he does not believe the tax package will lead to a hiring or investment boom, each of which could cause the economy to overheat and trigger inflation. Instead, Kashkari thinks businesses will use the extra money to continue buying back shares and raising dividends.
Both would be strongly supportive of still-higher equity prices in 2018, but do little to lift the wage stagnation that is the oft-cited source of middle-class angst.
Almost two years have passed since U.S. stocks dropped by 10%, the traditional definition of a correction. Over the past century, corrections have occurred about once every two years.
So while it is too early to call an end to the nearly 9-year-old bull market, volatility is likely to increase in coming months as faint clouds gather on the economic horizon. And over time, those clouds will rain heavily on one of the more profitable investment parades in history.
Just maybe not quite yet.