A Good Year for Investment Returns
2017 delivered impressive returns across stock markets both US and international. The S&P 500 gained 21.8%, The Dow Industrials 28.1% and the NASDAQ 29.7% . The best performing asset classes were US Large Cap Growth stocks (average gain 30.2%) with FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) gaining an average 49.7% on top of 2016's outstanding returns. General Electric bucked the generally favorable trend for large cap stocks, falling 44.7% in 2017.
By sector, information technology gained 38.8%, while telecommunications and energy trailed. Energy prices suffered from a glut of oil for most of the year, but rallied to $60.09 at year end after falling as low as $29.69 in February 2016. As OPEC and Russia both continue to cut production, oil prices should continue to rise in 2018.
International markets gained 25.7%, and US bonds returned 3.5%. A full report of all market indexes is here.
Both US and international markets benefited from positive economic conditions with world GDP growing about 3.6% and growth in the US accelerating above 3% in Q2 and Q3, and estimated at 3.3% for Q4. The earnings picture accounts for half of the gains in US markets this year. The 2017 tax legislation, anticipated by investors since the start of Q3, accounts for the other half of investment returns.
As we often explain, ultimately the stock market cares only about revenues, earnings and interest rates. The "fair value" of the market is derived from expectations of future cash flows (earnings or profits) discounted by expected future interest rates. If earnings are rising sharply while interest rates are static, stock prices will rise. If earnings are static while interest rates are rising, stock prices will fall. The most challenging time to forecast stock prices is when earnings are rising slowly and interest rates are rising as well (the environment of the past few years.) How did the tax bill goose stock prices?
In the US Congress, 42% of House members and 53% of Senators are lawyers by profession. As such, Congress members in general seem to have a poor understanding of how corporations plan investments. In the rhetoric of the tax bill advocates, cutting the top rate from 35% to 21% would free up cash for new projects AND enable corporations to raise pay. In fact, taxes have NO impact on investment decisions.
From business school 101: senior management establish a "hurdle rate" or minimum required rate of return necessary to move forward with a projects - let's say 15%. If a project's return is forecast to exceed 15%, it's a go. US corporations either have cash on the balance sheet (especially recent years) or can readily borrow to fund such projects. Part of the substantial cash build-up of the last few years is that corporations CAN'T find good projects that will deliver returns in excess of the hurdle rate.
An entirely separate department figures out how to minimize taxes across the entire corporation. Amazon, for example, is estimated to have paid ONLY 13.0% globally in taxes globally in recent years (9.3% in the US.)
The other congressional expectation is that US corporations would raise pay packages for rank and file employees. No. Corporations pay as much as is necessary to retain current talent and no more.
What will senior management do with next year's tax windfall? Senior managers are incentivized with stock options, which become more valuable as a company stock price rises. The fastest way to boost stock prices is to buy back stock and boost dividends. Investors anticipated that decision for 2018, bidding up stock prices an extra 10% in 2017. This gain is obvious good news for the 47% of Americans who own stocks (particularly the richest 10%, which include our clients, who own 80% of stocks.) However, no benefit accrues to the other 53% of Americans who don't own stocks (and mostly live paycheck to paycheck.)
Effect of the "Tax Reform" on Our Clients
There are plenty of good guides to the tax new code already published, so rather than create another, follow this link to a particularly succinct summary: Your Complete Guide to the 2018 Tax Changes. We were more interested in determining how our clients would be affected. 80% of our clients have between $1-10 million in total net worth and family income between $200-$700K. As we mentioned above, all saw their stock portfolios gain an extra 10% in 2017.
On average, the higher your family income, the more you will benefit from tax cuts, though the benefit tails off as early as 2023. 76% of taxpayers (anyone making less than $100K) will see little or no benefit, or may even pay more. Also, because the tax bill eliminated the individual mandate of Obamacare, the Congressional Budget Office estimates that 13 million American will lose their health insurance, with premiums jumping 10% for the rest.
Moody's estimates that housing prices will fall in many localities as the deductibility of state and property tax is capped at $10K, while the deductibility on mortgage interest is limited to the first $750K (down from the current $1 million) for new home purchases.
This chart from Moody's shows how your house's value might be impacted:
As the average American has 78% of their net worth in home equity (and only 22% in investments), this tax bill may deliver a blow to real estate markets at the exact moment when real estate was about to pass the high water mark set in May 2006.
Our clients live across the country and in Europe, with the highest concentrations in New York, New Jersey, Massachusetts, Texas, Pennsylvania and Connecticut. With the exception of Texas, these are all states with high state, local and property taxes. We've already heard from a number of clients that their taxes will be higher in 2018, primarily from losing the state and local tax deductions.
The biggest risk to the economy going forward is the projected increase to the national debt, currently already $20.6 trillion or 105% of US GDP or $19.6 trillion. Given that US runs a budget deficit, US Debt was already projected to rise to $10.1 trillion over the next decade, and these tax cuts will add another $1.5 trillion. Even at the most optimistic GDP growth rates of 2.5% annually, US GDP can only grow to $25.1 trillion versus $32.2 trillion in debt (a ratio of 128%.) These countries - Japan, Greece, Jamaica, Lebanon and Italy - all have debt ratios exceeding 128%, low economic growth, high unemployment (except Japan) and few options.
Ironically, this tax cut could CAUSE a recession - real estate prices fall, yet the Federal Reserve must raise short term rates to offset the inflationary effects of larger deficits. In an environment of "stagflation," stock prices would fall.
As we wrote earlier this year, a prudent tax policy would have been: raise taxes, spend half the extra revenue on debt reduction (create room for deficit spending in the future) and the other half on infrastructure projects (jobs AND economic development.)
The Trump Show
The most insane reality TV show of all time (and we cannot avert our eyes.) Who will be fired next after Michal Flynn, James Comey, Reince Priebus, Anthony Scaramucci (lasted 10 days,) Sean Spicer, Steve Bannon, Sebastian Gorka, Tom Price and latest, Omarosa Manigault? We're thinking Rex Tillerson or Jeff Sessions. Who will be indicted next after Michael Flynn, George Papadopoulos, Paul Manafort and Richard Gates. Our money is on Don Jr. and Jared Kushner. Who will Trump tweet-troll next? Don't forget the lies - 1,800 in office so far and counting. Trump doesn't make complex Hillary-Clinton-email-server lies; these are the lies you easily refute with Google on your iPhone. And finally, the big reveal for 2018 - what will we learn about Trump and "collusion" with the Russians?
So entertaining and yet... While the President flails and the United States descends into tribal conflict, China invests tens of billions in green technology, and India invests tens of billions in higher education. We may look back at this era as the moment when the US gave up our position as the number one economic power (first achieved in 1916 when the US overtook the British Empire.)
Determining that exact moment is a challenge and is dependent on both reliable economic statistics (hard to come by outside the US) and how purchasing power parity is determined. China could become the world's greatest economic power as early as 2018 or as late as 2030. Trump's exit of the Trans Pacific Partnership effectively ceded the markets defined by the 12 nations of the Pacific Rim to the Chinese in exchange for...nothing? China immediately stepped into the void (was previously excluded from the TPP) and will now receive preferential trading status instead of the US.
But perhaps we're being too critical of Trump. After all, the stock market made many record highs in 2017, with the S&P 500 up 21.8% and the US unemployment rate at the lowest level in 17 years at 4.1% as Trump has tweeted many times in recent months (why are we reminded of the cock who crowed because he thought he made the sun rise?) The problem we have is that there's little we can credit these gains to other than trends already in place.
During Obama's first year, US stocks rose 26.5%. Unemployment was 8.3% on Obama's inauguration day, peaked at 10.0% in October 2009, then fell to 4.7% by Trump's Inauguration day. Over 8 years, US stocks rose 221.5% (15.7%/year.)
All Trump has to do to be a hero is not screw up the current favorable economic conditions. Unfortunately, the net of Trump's first 11 months in office is a tax bill whose benefits accrue primarily to corporations and the 1% wealthiest families; actions which destabilize the health care markets while driving premiums higher; actions which allow banks and brokers to exploit American families without fear of penalty; and actions which roll back regulations and allow polluters to foul air and water. Trump approval rating hovers around 37%, so he still has fans (Republican, white, rural, blue-collar, high school educated.) What happens when those fans realize they've been conned? As of now, we expect at least one chamber of Congress, perhaps both, to flip Democratic in 2018.
Bitcoin & Crypto-Currencies
Several clients asked us in 2017 why we wouldn't "invest" in Bitcoin, Ethereum etc. Bitcoin first appeared in 2009 and quickly became popular with libertarians and technologists. Bitcoin was also attractive to drug dealers, crypto-hackers and human traffickers as an untraceable way to move large amounts of cash. We're fiduciaries - we're not touching ANYTHING that facilitates criminal activities.
In 2017, the price of Bitcoin soared 1900% from $959 to $19,189 by December 17th, Bitcoin entered mass market awareness with the number of new accounts growing at the rate of about 2 million/quarter. A recent study found that 30% of millennials (43% of male millennials) prefer Bitcoin to government bonds, 27% prefer Bitcoin to US stocks, 22% prefer Bitcoin to real estate, and 27% of millennials trust Bitcoins more than banks. So why won't we invest now?
Here are some charts of past manias:
Here's a current chart of Bitcoin as of 1/1/2018. The most recent price is $12,619, down 34% from the December 17th high:
If Bitcoin plays out like most manias, we're just past the "bull trap" stage and about to enter the "fear" stage. Our opinion: if you own Bitcoins right now, sell enough to take out your original investment. If the rest of your position goes to zero, at least you retrieved your original capital. If you bought in the last month, sell ALL, accept your losses and move on.
We wish you a happy and prosperous 2018!