It was a terrific year. Stocks recorded solid gains in the fourth quarter, pushing the major benchmarks further into record territory.
2017 ended on a positive note as the market produced quarterly gains for the ninth consecutive quarter. Volatility remained notably light, with the S&P 500 not recording a daily loss or gain of over 1% over the past three months. Large-caps and mid-caps outperformed small-caps, while growth stocks outpaced value across all market capitalizations. On a sector basis, durables (cars, appliances), technology, and financial stocks performed the best within the S&P while utilities underperformed.
Many felt the market continued to “melt up” in the final quarter of 2017 with a general sense of confidence about earnings and economic growth driving the indexes’ slow and steady ascent. Third quarter earnings reports appeared to drive the market’s gains early in the period, even if their overall tones were somewhat muted compared with earlier in the year. S&P 500 earnings increased by 6.4% in the third quarter (on a year over year comparison), a slowdown from the double-digit gains in the first and secondquarters, but over twice the anticipated rate before the quarter began.
Economic signals were also encouraging. Hurricane related disruptions led a sharp slowdown in payroll gains in September, but resilience in the labor market was confirmed later in the quarter when October and November payroll gains came in at their best back-to-back pace in over a year. The unemployment rate also fell to 4.1% in October, below its trough during the 2001-2007 expansion and at or below what many economists define as full employment. Both the manufacturing and service sectors were expanding at the fastest pace in over a decade and existing and new home sales reached their best level since 2007. Consumer confidence reached levels not seen since 2000.
The issue of corporate tax reform drove much of Wall Street’s gains in the second half of the quarter. Throughout much of October and early November, investors appeared skeptical as to whether Republicans would be able to come to a consensus on how much and where to cut tax rates. The hurdles appeared particularly high in the Senate, but stocks moved higher as it became clear in late November that bill would pass through the upper chamber. The reform rally continued into early December as it became known that the corporate tax rate would decline from the current 35% to 21%.
Outlook for the 1st Quarter 2018:
The U.S. equity bull market that began in the wake of the global financial crisis has exceeded the expectations of many investors. We believe the fundamentals remain positive for continued upward stock movement, but investors should temper their expectations given the likelihood of more muted returns amid potentially greater volatility. To be sure, the general economic backdrop remains constructive with improving global growth. U.S. economic growth has been somewhat sluggish, but a moderate expansion could extend the growth cycle. Consumer and corporate balance sheets and the housing market are generally healthy. Inflation remains tame for now. Business investment is improving.
Corporate earnings rebounded in 2017, and the consensus forecast is for them to remain on a growth path over the next couple of years, particularly the technology and health care companies. Earnings could be pressured, however, by declining profit margins as interest rates rise and wage growth accelerates if labor markets tighten further. The rigorous corporate cost-cutting seen in recent years may leave little additional room to protect margins if price competition and/or wage pressures intensify. Dollar strength could undermine profits for U.S. based multinationals, which would see a decline in the value of their foreign earnings.
Profit margins already are near peak levels as margin expansion has thus far accounted for a greater proportion of earnings growth in this cycle than revenue growth. So rising revenues from increased demand will be needed to offset margin declines, drive earnings growth, and support valuation multiples.
We believe that meaningful corporate tax reductions can boost after-tax earnings. We have already seen that Apple will bring nearly all of its overseas cash of $250 billion back home and pay a repatriation tax of $38 billion to the U.S. Treasury. Apple plans to invest $300 billion in infrastructure over the coming years. We have also seen several companies announce bonuses of $1,000 to all employees and credit the tax reduction as a reason. We believe that these lower corporate tax rates will increase corporate profits, increase employment and expand corporate investment substantially.
Bruce A. Kraig Associates
An unbiased, independent RIA serving our clients' best interests since 1991 Investment Management 1650 Fox Crossing . West Chester . Pennsylvania . 19380 610 . 644 . 3468 Info@KraigInvestmentManagement.com