By any standard, in 2017 the stock market had a great year, gaining more than 20%. But, was that kind of gain justified, or should it worry us, especially after the market had already tripled in recent years? Of course, opinions differ. But, I think it’s useful to understand the range of viewpoints on 2017 in order to better prepare for 2018, and beyond. Below I provide the “bull” and “bear” cases and then offer some observations.
As measured by the S&P 500 index, the US market gained nearly 22% in 2017. While this may seem like a lot, there is a supporting argument that makes perfect sense. Here’s the logic: As you may know, at the end of December Congress overhauled our tax system, reducing the corporate tax rate from 35% down to just 21%. To understand how this might affect stock prices, let’s look at a simplified example (this gets a little technical, but I think it’s worth following):
Suppose ABC Corporation earned a $100 profit last year and expects to earn another $100 this year. In 2017, under the old regime, this company’s tax bill would have been 35%, or $35, making its after-tax income $65. But, this year, under the new rules, this same company’s tax bill will be just 21%, or $21, making its after-tax income $79. If you do the math, you’ll notice that this profit increase, from $65 in 2017 to $79 in 2018, works out to roughly 22%. That is virtually identical to the stock market’s gain last year.
So, the bull case for the stock market is that last year’s gains were perfectly logical: If a company’s profits increase by 22%, its stock price should also appreciate by 22% — all else being equal.
The bear case starts by noting that there is a fair amount of coincidence in these two 22% numbers. Yes, I do believe the market rose in anticipation of tax cuts, but the math isn’t as simple as I made it out to be. First of all, even under the old regime, only a minority of companies paid the statutory 35% rate. Last year, for example, Apple paid just 25%, Google paid 22% and GE paid no tax at all. And, at an individual company level, there was no relationship between the size of the tax cut and the size of the stock move.
Also, a change to US corporate tax rates doesn’t explain why last year an index of emerging markets stocks — including Brazil, Russia and China — rose nearly 40%. Those countries didn’t benefit from our tax cuts.
Finally, an objective measure of the market points to significant overvaluation. Bob Shiller, a Yale professor who has a better-than-average track record predicting economic cycles, maintains a measure he calls the Cyclically Adjusted P/E Ratio (“CAPE”), and it doesn’t look good. Right now it’s higher than it was in 1929, just before the Depression. Look online, and you’ll quickly turn up headlines like this: “The ‘CAPE To Saving Rate’ Ratio Signals A Terrible 2018 For U.S. Stocks.”
Where does this leave us? As a former colleague used to say, it’s all “clear as mud.” But, while that conclusion might seem unsatisfying, I think it teaches us two important realities about the stock market:
There is no one universal measure of value. Yes, there are some dire headlines about the CAPE Ratio, but opinions do differ. You can also find headlines like this:
“Why The Shiller CAPE Ratio Is Misleading Right Now”
“CAPE Has a Dismal Record as Predictor of Stock Performance”
In other words, reasonable people can disagree, and no one can say with scientific certainty that the market is overvalued. No one knows what will happen next. Therefore, the most important thing for your investments is to be sure that you are not dependent upon short-term market movements in order to meet your living expenses. If you worry that you are, then you should waste no time in revisiting your portfolio’s asset allocation.
Markets are forward-looking. Wall Street is staffed by armies of investment analysts who make it their job to follow every development that could possibly impact the market. And, in an effort to get ahead of each other, they usually start placing their bets well in advance of important events. That’s why the market started to turn around early in 2009, for example, even while unemployment was still rising. Traders were looking ahead. And that is, I believe, what happened last year, in advance of the tax cuts, even though the precise impact varied from company to company. This is not to say that 2018 won’t see stock market gains, but it is important to recognize that professional investors are always looking forward and will react well in advance of whatever they see coming next. This is another reason why, if you rely on regular withdrawals from your portfolio, it is vital to have an asset allocation that would be able to protect you against future, unexpected events.
It is a frustrating reality that finance, which appears quantitative, is hardly scientific. Emotions, opinions, biases and unexpected events account for most of what happens on Wall Street. That’s why it’s so important to structure your portfolio so that you won’t be unduly impacted regardless of which way the winds blow in 2018.