Quarterly Commentary

Market Update

November 10, 2017

Greetings,

The Proposed US Tax Bill by House Republicans would make the most sweeping changes to the US tax code in over thirty years. The clear winner, if the proposals become law, would be US corporations, with a reduction of the top tax rate from 35% to 20%. Speaker Paul Ryan is confident that the proposed legislation would help to make the United States more competitive globally. He is optimistic that the tax changes could shake loose a significant piece of the $2.5 trillion in cash that US multinational companies have in overseas accounts. While none of this is law yet, with a looming battle in the Senate, there is higher optimism now that a new tax code could be passed before Christmas.

At South Texas Money Management, we have expected the significantly lower corporate tax rates, and described them over the past year as “the low hanging fruit,” and explained that much of the bullish stock market run has been in anticipation of the resulting boost to corporate earnings. After all, the valuation of the broad stock market is now, and generally always is, based on corporate earnings and projected growth of those earnings. My expectation is that the rise in stock prices may broaden, actually, when the final tax law details are known. Banks, for example, could be strong beneficiaries.  So far this year, it has been a narrow large-cap growth stock rally, particularly in the technology sector, that has pushed the averages. Diversified portfolios have been hampered in relative terms, but are still experiencing very attractive total returns.

With this sneak peak of the compromises made in order to fund the corporate tax rate reductions, I feel that we advised our clients appropriately, not to delay their own tax decisions, thinking that individual tax payers could receive cuts in their own income or capital gains rate. In this proposed tax bill, that would not be the case in most situations.

It is clear that House Republicans are believers in The Laffer Curve, the economic theory that tax reduction boosts spending, and therefore, lifts the economy. They are counting on US corporations to invest more in the US economy by investing funds held hostage offshore by high US tax rates. The logic is that they would build plants, hire more people, invest in technology, etc. - projects to propel economic growth.

At its surface, it makes sense and certainly President Trump will put the pressure on US business leaders to buy into that scenario. And, no doubt, companies could use a lot of that cash to initiate or boost dividends and/or buy back shares, even though now, at a lofty price.  Good for stock holders, right?

But, there is a bit of a leap of good faith built into this strategy that favors corporations over individuals. The US Housing Industry has been one of the most significant growth engines over the past decade and this proposed legislation penalizes that sector to some extent with some future home buyers losing mortgage interest deductions as well as state and local tax deductions. These changes could put downward pressure on residential home valuations, the dominant asset of many individuals. Perhaps the Senate will recognize that risk to such an important industry, one just starting to benefit by first time millennial home buyers. 

My concern with current US unemployment at 4.10%, a 17-year low, is that wage inflation could likely start rising with more hiring by US corporations for their new projects. Some wage inflation is good for consumers, but inadequate job training is keeping many out of the work force. I have seen nothing in the proposed Bill that provides for educational spending or job training. US companies may be very challenged to find the labor for their US projects. Yes, it is all a bit of an experiment. 

Our optimism that corporate tax reductions would happen and boost stock prices has kept us fully invested in portfolios. The now five year annualized rate on stocks in the STMM all equity composite is approximately 12% with a total return of approximately 11%, net of fees and cash returns. Even the “balanced” portfolios with both stocks and bonds and 40% lower volatility is approximately 6.6% on a five-year annualized basis.

We continue to maintain our discipline of strategic diversification in style (value and growth) and sectors.  Quite simply, it is the math. This chart (click here to view chart) shows how damaging stock market corrections are to accumulating long-term wealth. The more you lose, the more you have to recover to get back to even. This graph shows two of the largest followed stock indexes. The S&P 500 and the MSCI World Stock Index are shown as the bottom two lines. The upper two lines, however, represent the exact same indexes with less upside during market upturns but markedly better downside protection, which results in better long-term returns. This is why we diversify. Our goal is to accumulate your wealth long-term and reduce the downside risk to portfolios, especially in ­­­­frothy stock markets as they exist today. 

Lastly, our meetings last month with Amy Myers Jaffe, our energy advisor, formerly of the Baker Energy Institute and the University of California Davis, and now with the US Council on Foreign Relations, concluded that rising risks in the Middle East could push up oil prices near-term and refocus on global Middle East concerns.  Longer-term, we are optimistic that oil price spikes will be better controlled by growing shale development in the US.

I encourage you to watch our third quarter webcast. In this presentation I am joining Dr. Jim Kee, President and Chief Economist; and Christian Ledoux, CFA®, EVP, Director of Equity Research and Senior Portfolio Manager. Please click here to view the webcast.

Finally, we are pleased to share with you our quarterly nonprofit spotlight featuring the Association of Fundraising Professionals (AFP). The AFP works to advance philanthropy through advocacy, research, education and certification programs, as well as fosters the development and growth of fundraising professionals, while promoting high ethical standards in the fundraising profession.

Thank you for being our client. 

Sincerely,

Jeanie Wyatt, CFA®
Chief Executive Officer & Chief Investment Officer

 

 

Disclosures

This letter is not intended to constitute investment advice. Market and economic views are subject to change without notice and may be untimely when presented here. You are advised not to infer or assume that any securities, sectors, or markets described in this letter were or will be profitable. Securities identified in this letter do not represent all of the securities purchased, sold, or recommended for advisory clients, and you should not assume that the recommendations made in the future will be profitable or will equal the performance of the securities identified above. A complete list of all equity recommendations made by STMM during the past year is available upon request. Past performance is not indicative of future results. There is a risk of loss.

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