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Taxing

It’s been a taxing year in many respects, but clearly not for investors in US stocks.    Year to date, the total return to stocks (measured by the S&P 500) is a robust 20.5%.  With the exception of a modest miss in March, returns have been positive for 13 consecutive months.  This is the longest period of consecutive returns, and with the lowest month over month standard deviation, going all the way back to 1982.

The goodness extends beyond the US.  Year to date, stock markets in most major countries around the world have produced handsome returns.  These markets include traditional economic juggernauts (Germany +27%), old line economies experiencing difficulties with their neighbors (UK +16%) and even economies no one else seems to like all that much (Russia +1%).

In spite of the soap opera in Washington, there are a number of factors propelling our stock market: earnings growth is inflecting upward, oil prices are stable, economies around the world are echoing our economic expansion, central banks around the globe are withdrawing stimulus (inflation trade) and Wall Street’s animal spirits are running wild with anticipation of the benefits from tax-cuts for corporate America.

Seasonal return patterns tell a story.  Since 1982, December is clearly the best month for stocks, with a positive return (batting average) 77% of the time and a net average return of 1.75%.  The next best month is April, with a 72% average and a net average return of 1.64%.

Stock prices have risen, and are no longer cheap.  According to FactSet Research, the trailing P/E ratio for the S&P 500 is 21.  For context, at the apex of the dot com bubble, March 2000, the market’s P/E ratio was a healthy 30.  In contrast, at the low point of the financial crisis, March 2009, the market’s P/E ratio was 10.  So, best of times, worst of times – today we are smack in the middle.

 The overarching issue on everyone’s mind is taxes.  The drama is playing out inside the Beltway, but the repercussions are being felt on Wall Street.  The effort is to spin a new tax code, lowering taxes and simultaneously spurring future growth.  Investors are licking their chops. Income taxes were briefly imposed in 1861 to help pay for the civil war.  The 3% tax was repealed in 1872.  In 1913, the 16th amendment gave Congress the authority to levy a federal tax on income.  At that time, only a small number of people actually paid. 

 Our current progressive system has taxpayers with incomes over $200,000 paying nearly 60% of all federal income taxes.   Based on early analysis of the bill, the majority of tax cuts will benefit folks in this income group, and more so for higher income groups.

 The last time a tax cut was proposed, in 2001, the Congressional Budget Office projected a $5.6 trillion surplus over 10 years.  Today, the budget office forecasts deficits will total $10.1 trillion over the next decade.  The deficit is expected to top $1 trillion a year in 2022.  Federal debt held by the public is at the highest level since shortly after World War II, at 77 percent of GDP. (NYT 9/28/17)  The political imperative to cut taxes has now superseded any view toward fiscal prudence.

 We’ve done some analysis, and a reduction in corporate taxes will boost earnings for stocks.  The puzzle is which stocks, and to what degree.  Our working assumption is that some benefit is already priced into stocks, and there is the potential for more, though this will require clear and well communicated legislation.

 At some point, I expect the market to revert to the mean.  Consumer confidence is high, as is confidence in the stock market.  These can be yellow lights.  Since Thanksgiving, the market has begun to rotate, away from the year’s big gainers, and into “safer” low growth names.  We have been anticipating this shift in leadership from growth to value.  If the rotation persists, we will look to take more profits in our highest performing stocks before the end of December.  If we wait until the new tax year to rebalance, we may be faced with a multitude of investors with the same clever thought.  My preference is to stay in front of the pack, and if we owe capital gains, to pay them from this year’s generous profits.  Please feel free to check in if you have any concerns.

Bruce Hotaling, CFA

Managing Partner

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