Can you believe yet another year has come to an end? Meanwhile, the news flow from Washington has been non-stop. Even though the Democrats and Republicans can't seem to find common ground, the Republicans, by holding a majority, have been able to jam through a tax cut package which has already been signed into law by the president. The investigation into Russian collusion seems to be far from over. Tensions with North Korea seem to be ratcheting up. There are continued threats of terrorism around the world, along with the ongoing outbreaks of major cyber-attacks. Yet, with a mountain of worry to surmount, the stock market has continued its climb this year, with little, if any volatility to the down side! At the writing of this letter, the S&P 500 Index is up close to 20% and some International Indexes are up even more than that. We have enclosed a handout that shows the 2017 performance of our core Vanguard Exchange Traded Funds for your reference.
What happened to the "slow growth/lower return environment for the next 10 years", as outlined by many of the stock market's largest asset providers? Our advice would be to not get too complacent and continue to plan for lower returns over time. As always, we believe that proper asset allocation is key to long term success. As pointed out in the latest issue of Financial Advisor Magazine, keeping the long term in focus shows us that since January 2000, the S&P 500 Index has averaged only a 5.3% return, including reinvested dividends. This statistic helps us to keep this significant rise in stocks in perspective. Our goal is always to help our clients be prepared rather than surprised.
Currently, we have had one of the longest running bull markets in modern history. So what is driving this? Today we have an economy in which the latest two quarterly readings of the GDP showed 3.1% & 3.2% respectively. We have a strong job market with low unemployment and a relatively subdued inflation rate. The Federal Reserve appears, for the moment, as though it can walk on water with its slow unwinding of the balance sheet and slow increase in interest rates. It's interesting to note that many believe with synchronized global economic growth and continued easy global monetary policies, (see attached handout: "IMF Continues to Believe World Growth Will Accelerate") the Global Economy is likely to continue its growth trend into 2018.
When you step away from all the noise, corporate earnings are really what drives stock prices. The continued growth of corporate earnings and the prospect of lower corporate tax rates are some of what is fueling this stock market rally. The price to earnings ratio is a number derived by dividing a company's current stock price by their earnings per share. At current levels, the average of the S&P 500 companies is somewhere between 21 and 22 (the 25 year average is closer to 18). We have enclosed a chart titled "US Return Expectations" which predicts the forward 12 month returns, when current valuation is factored in. At these levels, historically, the average return has been a negative 1.3%.
A study by Michael Thompson, president of Standard & Poor's Investment Services reveals that every 1% decrease in the Corporate Tax rate could potentially add $1.31 per share to the S&P 500 earnings. If you look at a current 35% Corporate Tax Rate and with a reduction to a 21% Corporate Tax rate, you could potentially see an increase in earnings for these companies. (Keep in mind many corporations are not paying an effective tax rate of 35%, when including all deductions). This could still mean that Price to Earnings ratios may not be quite as elevated as they appear.
Long Term Interest rates have held steady, while interest rates on the shorter end of the curve have increased. The Fed has now moved rates 3 times this year, increasing the Fed Funds rate each time by 25 basis points, to a current level of 1.25% - 1.5%. The 10 Year Treasury started the year at 2.44% and finished the year at about the same level. The 2 Year Treasury yield rose from 1.2% at the start of the year to approximately 1.9% at year end. This movement has led to a flattening of the yield curve, which is certainly something to monitor, since in the past, it has meant that the US economy is in the middle of a tightening cycle, not the beginning. Even though many economists expected interest rates to slowly rise in time, there are some larger forces that may keep longer term rates low. However, as we enter the early part of 2018, one caveat to that expectation which we will watch for, is if the optimism from the tax cuts starts to pressure the rates upwards.
An interesting piece from Kiplinger's Personal Finance Advisor stated that the top 10% of all tax filers (those with AGI's of $138,031 or more) bore 70.6% of the overall Federal Income tax burden. While on the other end of the spectrum, 70.6 million filers, in the bottom 50% of earners, paid 2.8% of the Federal income tax total. Early indications are that Washington might not be doing us any favors by reducing our own individual income tax liabilities. Yes, tax rates may go down a bit but limitations on State income tax and real estate tax deductions may offset those reduced tax rates. We will certainly address more about the tax changes and how they may impact your investments in our next quarterly letter. As our investment committee continues to review the current state of the economy, equity valuations, interest rates and their impacts on the core group of Vanguard Funds that we recommend.
While it is always nice to review the current state of the economy and learn a few interesting facts, many of you may ask, "what does this mean for my investment plan?" We continue to recommend that you take advantage of this move up in the market and re-balance your portfolio. Is there need for a significant distribution at some point in the upcoming year? Maybe now is the time to draw up some of the cash needed. Or are you feeling anxious about your portfolio after this big run up in values? While it's possible that 2018 could still be a decent year for equities, with the current backdrop, it's also important that we prepare ourselves for a return to some volatility.
Please do not hesitate to call us with any questions on this information or concerns that you may have. Wishing you all a very Happy and Healthy New Year!
Bryan Bastoni, CFP
CERTIFIED FINANCIAL PLANNER, TM