Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.
EQ: The Trump administration unveiled the framework for its tax reform plan this week, and the reactions have been mixed for the most part. Was this what the market was hoping to see?
Stovall: I think the market was hoping to see anything that resembled a tax cut be issued by the Trump administration. At the same time, because they know that it’s the beginning of a lengthy compromise and negotiation, it’s not overly specific as to its details.
The corporate rate being declined from 35% to 20% is not really a surprise because Congress will probably end up with something close to 25%. Reducing the tax brackets into three, and not reducing dramatically the tax on the wealthiest category was also something that the Republicans were hoping would be digestible by the Democrats. But it seems as if some economists and Democrats were already pushing back, so the lengthy negotiation process now begins.
But investors were certainly heartened by the introduction of some sort of tax plan because the markets responded favorably.
EQ: On a separate front, rhetoric between the US and North Korea have escalated to the point that North Korea accused the US of declaring war. Is this sabre rattling between the two countries impacting the market?
Stovall: I think it’s putting a pall over the overall exuberance and optimism that investors might otherwise be having, because how do you model the irrational actions of a despot? I think that there’s a very big worry out there that nobody really knows for sure what North Korea wants, and maybe the guy is just crazy enough to press the button. I do think people in general are saying that not even the leader of North Korea could be that crazy, but at the same time, it adds little bit of a worry in the back of their minds, which probably is holding back share price appreciation.
EQ: The final quarter of the year kicks off next week, and as you pointed out in this week’s Sector Watch Report, the market may be worried about a more hawkish tone from the Fed going forward. Are these worries premature?
Stovall: Well, I think that they might be premature because right now the Fed funds rate is in the target range of 1% to 1.25%. If this were a normal time, the Fed funds rate would be about 1.3 percentage points above their rate of inflation, or at about 3%. Yet, we’re about a third of that. So, the Fed has a long way to go before getting back to a more normal Fed funds to inflation trade-off, and has at least two rate increases to go to even make this a net neutral inflation policy.
So, interest rates really need to rise a lot more in order for them to adversely affect growth in the economy, in my opinion. As a result, I don’t think investors are going to be too unnerved by it because stocks still represent a more attractive alternative to bonds.
EQ: On the flipside, there have been some concerns that the Fed may be falling behind the eight ball. Is that more of a concern than an overly hawkish Fed, considering that it will take a couple rate hikes to get back to a normal environment?
Stovall: I think to some it is a concern in that they feel as if the Fed is too far behind the curve like it was back before the financial crisis, and that they are again keeping rates too low for too long, which therefore is contributing to the increase in asset valuations. Who is to say whether they are to blame? Especially since their mandate is to keep employment up and inflation down, and that’s pretty much it. But everyone likes to point fingers at those who are in charge, and the Fed is actually no different.
EQ: The final quarter of the year has historically been the best performing one for the market. How good has the last three months of the year been for investors?
Stovall: Going back to 1990, the S&P 500 gained an average of almost 5% in the fourth quarter, and was higher 81% of the time. That’s obviously not a guarantee that will be the case this time around, but it certainly is encouraging for investors. Also, we find that on average, every single sector was in positive territory in the fourth quarter with the strength really coming from the cyclical Consumer Discretionary and Information Technology sectors.
In terms of batting average, the frequency of advance for all sectors was up anywhere from two out of every three years to as much as 85% of the time, as was seen by the Consumer Discretionary, Health Care and Consumer Staples categories. So, the frequency and the magnitude of advance has been quite impressive in the fourth quarter of the year going back to 1990, but obviously there’s no guarantee that will be the case this time around.
EQ: Considering some of the geopolitical and economic concerns bubbling underneath the surface, which we touch on above, how cautious should investors approach the final stretch of the year with regards to their portfolios?
Stovall: CFRA’s Investment Policy Committee did indeed raise its 12-month target for the S&P 500 to 2,640, which implies a near-6% price appreciation over the coming year. We still think there’s upside potential, but we are not advising that investors get overly aggressive. We’re 8.5 years into this bull market, and are looking at the second most expensive bull market since World War II on P/E ratio alone—even though very low inflationary trends tend to be supportive of high P/E ratios.
So, I would say to investors, don’t try to time the market by getting out too soon because you might end up getting surprised. It’s estimated that for every percentage point reduction in the tax rate, it will add to 1% of earnings growth for the S&P 500. So, instead of being up about 10% for 2018, earnings might be up 20%. You would have to be able to explain that away should you decide to bail out now only to miss out on a substantial move later one.
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