Zeller Kern’s Investment Monitor

This Ride Is Not Over

December 6, 2017

By Steve Zeller

In what looks like a banner year for the stock market in 2017, the major indexes have roared up to record levels. Although, we experienced some wild volatility on Friday of last week, as NBC News released a totally false report regarding the Trump administration, and was not refuted for nearly three hours. The Dow Jones dropped 350 points and the S&P 500 plummeted to 2605. Finally, when the story was retracted, the markets rallied back close to previous levels. One observation that you can take away from this, is that the markets actually do have the ability to undergo a massive decline very quickly, and may give indication to what could be in store down the road.

As it stands now, we are experiencing an impressive year performance wise for the market, with the major indices up well into a healthy double digit territory.  As of Friday’s market close, the Dow Jones Industrial Average is up 25.49%, the S&P 500 is up 20.25%, and the NASDAQ Composite is up 27.20%. Other index, such as the Russell 2000 Small Company Index, is up 14.59% and the S&P Midcap 400 Index is up 15.71% (source: Morningstar.com and performance includes the reinvestment of dividends).

As we have mentioned in previous issues of the Investment Monitor, our expectations had been for the S&P 500 to reach the 2650 level before any market top would be rendered. That has certainly happened as the S&P 500 is now at the 2658 level, and the Dow Jones Industrial Average is currently at the 24,500 level. Even though we are concerned of the current market conditions, and we believe that a major market top, potentially, will be realized within the next 6 months, our estimates project a higher possibility that we will continue to see further new highs, with the S&P 500 potentially entering into the 2760 to 2835 territory.

As expected, investors are receiving a tax cut that includes a significant reduction in the corporate tax rate, and it is very positive for stocks and is fueling a significant market rally that should continue with a Santa Claus Rally through the holidays. But that might not go without some volatility, with several factors that could potentially disrupt things.  As Brad McMillan of Commonwealth Financial, recently pointed out in a November 29th article, there are a few things in Washington that could feasibly disrupt the ride, including a government shutdown over the budget, just days away when the pending deadline on December 8th arrives, which the deadline for the debt ceiling extension ends. The government cannot borrow any more money, and if Congress can’t come to any agreement, the government shuts down. There are other things that fuel some uncertainty in Washington such as the widening political gap. Case in point, Democrats recently pulled out of a meeting with President Trump to discuss the debt ceiling and budget. As Brad McMillan points out, a significant part of the tax reform debate centered on increasing the deficit, would require multiple votes to increase the debt ceiling, which makes the timing worse than usual. As a result, there is a greater likelihood of a shutdown.

A shut down, arguably, would have a negative impact on GDP and could measurably impact the economy, every week that the government is not operating and employees are not getting paid. As a result, this would feasibly provide some kindling for market volatility, especially if you throw in the prospects for short term interest rates to rise driven by the Fed. Although these conditions aren’t show stoppers for the economy, they have the potential to create some significant bumps along the way.

On a positive note, it was reported last week that Real Gross Domestic Product (GDP) increased at an annual rate of 3.3% in the third quarter of 2017, which is according to the “second estimate” provided by the Bureau of Economic Analysis.

Click chart to enlarge

Also, Real Gross Domestic Income increased 2.5% in the third quarter, an increase from 2.3% reported for the second quarter. This is good news, and both of these latest figures made a positive impact on the U.S. economic activity measurement, which rose to 2.9% in the third quarter. If the corporate tax cuts come to fruition, we still are of the opinion that it will provide further tail winds in the short run for the market and give fuel for the S&P 500 to break through the 2800 level.

The other thing to keep in mind is that the changes in the tax laws will allow U.S. companies to repatriate an estimated $2.6 trillion in retained earnings that are held abroad in other countries, at a proposed rate of either 14% proposed by the House, or 14.5% proposed by the Senate, instead of 35%. The share of these accumulated profits that are not in U.S. dollars is estimated to be between 25% and 40%, which is significant. That means that when these funds are brought back over to the U.S., they are converted to U.S. dollars, which is bullish for this currency. It is also bullish or positive for the economy in that, these funds may be used for further capital expenditures and stock share buybacks, which buybacks are positive for earnings per share valuations (EPS).

Another economic indicator that we haven’t mentioned in a while is the Baltic Dry Index, a measurement of shipping activity, has broken out into an uptrend and is currently testing four-year highs.

On the negative side of things, the bond market is showing signs of concern with the flattening of the yield curve over the past several weeks. Typically, when this happens, it is a reflection that bond investors are concerned about a recession coming into the not too distant future. In our opinion, it is more likely due to other reasons, and is based on technicals that have to do with institutional investors unwinding credit spreads. Another observation is that if bond investors are taking into account a reduction in corporate taxes, they still don’t see any kind of reflationary growth happening anytime soon.

As far as the real impacts of the tax cut on the economy, the outlook from the latest survey by the National Association of Business Economists in November, reveals most respondents expect a modest economic impact. According to a recent posting by Dave Rosenberg of Gluskin Sheff, the consensus is for a .3% boost to overall GDP growth, which the consensus also sees a 2.5% growth in GDP in 2018, up from 2.2% in 2017, and they actually see a slowing in real consumer spending in 2018, to 2.5% from 2.8% in 2017. However, the NABE raised their corporate earnings growth estimate to 6.2%, and suggests that even with a 17.5X forward multiple, the consensus is pricing in a trend of double digit market growth.

But, as we have also pointed out in previous issues of the Investment Monitor, it’s confidence in market trends that fuels an ending to a bull market. A lot of what is in place, currently, are conditions that you saw back in 1999. Margin debt is now at an all-time high (debt investors borrow in their investment account to buy more stocks and is collateralized by the current holdings in their account). This is a condition often seen at market tops. Furthermore, other conditions exist such as historically high investor confidence, historically high stock valuations, especially if you measure it by the Shiller P/E ratio, and a bull market duration that is now over 8.5 years old. In other words, just as investors feel that there is no place else to go, but up, is when the party ends. Outlooks, investor confidence, and risk taking across many asset classes and categories, are reaching extremes.  Our latest guess is that we will likely see some trouble as early as the second quarter of 2018 – we’ll just have to see.

Click chart to enlarge

Looking back on last week
Last week’s action continued to move higher as the Dow Jones led the way up 2.9% followed by the S&P 500 and the Russell which added 1.5% and 1.2% respectively. The primary laggard last week was the NASDAQ as it was down 0.6% as many of the major tech stocks declined due to profit taking after a huge year.
While most of the week was waiting for the Senate’s vote on the tax reform bill, markets became more optimistic after McCain indicated he would vote for the bill and would not obstruct tax reform like he did in the repeal of the Affordable Healthcare Act. Market participants took this as a positive.
Markets steadily moved higher after Monday’s flat action as we saw a rally into Thursday as the S&P 500 continued to move into all-time new highs.
On Friday, we saw a flat opening but after a fake new story was released about the investigation with Michael Flynn, markets took a very steep drop until the story was refuted as we dropped all the way down some 350 point basis the Dow Jones. After the story was refuted, the markets steadily ground back just to close slightly lower on the session as the week finished up 1.53% for the S&P 500.
Friday's action kicked up the volatility substantially as we saw the VIX move as high as 14.58 intraday while the S&P 500 declined all the way down to the 2605.52 level. While this decline would be perceived to be somewhat artificial due to the impact of this new story, it did trade down to a major support level and then reversed to close near the high of the session.
As mentioned before, some new objectives that could come back into play suggesting a potential move to the 2760/2835 levels. While these numbers sound huge, they represent a 5 to 7% gain. So, these are certainly not unrealistic numbers and also something that would be very easily met as we go into a seasonal tendency in January and February for the markets to move higher.

Best Wishes,

Zeller Kern Investment Committee