January 23, 2018
Dow Jones Average: 26,211
S&P 500 Index: 2,839
On December 22nd the “Tax Cuts and Jobs Act” was signed into law. There are myriad details within the bill, all of which carry great significance for particular constituencies. Some people will be angered and others delighted by what all this fine print contains. In many respects the bill further complicates the tax code. There are also the larger questions that hang over this tax cut: whether now, a decade into an economic recovery, is the appropriate time for fiscal stimulus that increases the Federal deficit, and whether the stimulus will be distributed fairly. We will put those questions aside and discuss what we view as the signature element of the tax plan, the reduction in the corporate tax rate. It is central to a discussion of stock market action in the final quarter of 2017, and it shines a spotlight on corporate decision-making.
The market posted a strong return through September, with some of the gain tied to anticipation of a corporate tax cut. As the final details were being worked out late in the year, the market rally accelerated and the broad indices finished with their strongest year since 2013. The reason for this advance is somewhat obvious. The corporate tax rate is set to fall from 35% to 21% in 2018, creating the possibility of higher profits for many companies. One can infer that the stock market expected most of the tax savings to flow through to shareholders in the form of higher profits, higher dividends and larger stock buybacks.
It is not a foregone conclusion that companies will deliver most of the tax cut straight to their shareholders. In fact, the name of the bill optimistically implies a positive outcome for other stakeholders. If this piece of legislation is to create more good jobs, companies will have to take these potential profits and spend the money on hiring and training employees, paying better wages, and investing in modern plants and equipment. There can be tension between the immediate interest of shareholders and the welfare of employees. Companies are just starting to tell shareholders and the public how they intend to distribute the tax windfall. An example that has already attracted the interest of investors is Bank of New York/Mellon. Last week the CEO of Bank of New York/Mellon said, “At this point, we are anticipating that the impact of the lower tax rate would be almost entirely offset by actions that we will take to reinvest this benefit in our employees and our business.” This disappointed investors and the stock fell nearly 5% as a result. It is a microcosm of the conflict that exists right now between the various corporate stakeholders, which includes shareholders, customers, and employees, over how this new money will be shared. If the balance largely goes to shareholders, it will help buoy a relatively expensive stock market in the near term, but accomplish little of the long-term economic goals of the legislation.
We began as skeptics of how this money was to be distributed. The last time Republicans held sway in Congress they created a temporary tax reprieve on profits sheltered overseas. Much of that money came back into the U.S. and was spent on stock buybacks, which we viewed as economically unproductive. However, there does seem to be a growing self-awareness and long-term vision among many companies and their executives. They have, in essence, been handed the keys to the economy by an incredibly pro-business administration and much of the country is now watching with a critical eye to see how they behave. It is worth noting that just last week Larry Fink, CEO of BlackRock, one of the largest and most influential investment firms in the world, wrote an impassioned open letter to all CEOs. In it he controversially called on every company to “not only deliver financial performance, but also show how it makes a positive contribution to society”, to “benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.” Fink’s statement caused a stir in an investment world that is laser focused on immediate, short-term maximization of profit for shareholders. As socially responsible investment managers we wholeheartedly agree with his sentiment, and consider his advice to be the most logical and appropriate way to manage a business over an extended time frame. If one is a patient investor with a broad view that includes employees, customers, and community, the interests of those stakeholders and shareholders can be seen as aligned. The current moment in the economy is fascinating as companies declare how they intend to use their tax windfall. In so doing, many have a platform, welcome or not, to weigh in on the treatment of diverse stakeholders.
The challenge for market participants is navigating an increasingly exuberant and expensive stock market environment. It will take a near perfect economic climate to justify and sustain current market prices. Many investors believe that business conditions are ideal, and for now there is support for their optimism. The global economy is growing in a synchronized fashion that includes nearly all major countries. In particular, the United States is a bit of a Goldilocks economy for stocks. By this we mean that the economy is running hot enough to generate increased profits and employment, but not so hot as to create any unwanted inflationary pressure that can wreak havoc on bond and stock prices. Money is flowing into the stock market every month, creating a rewarding environment for existing investors in which stocks seem to only go up with minimal, daily volatility.
We were pleased with how our stock selections performed in 2017. While our technology selections led the way, there was also strong price appreciation in most consumer, industrial, and financial holdings. After such a big run we are concerned that abnormally high valuations on stocks could produce a more pronounced correction. It is not at all clear what could prompt a decline in stock prices, which makes the timing of an exit imprecise at best. It could be higher interest rates that eventually trigger a movement of money from stocks to bonds that at long last pay a palatable rate of return. In our opinion the best strategy is to start taking some profits on successful positions from last year that have reached full valuation. We anticipate more such profit taking if the market climbs higher, slowly bringing down our clients’ exposure to stocks.
Our bond portfolio is generally short-term in nature, which is designed to insulate investors to some extent from rising interest rates. For most clients we have a series of very short-term treasury bonds that we will continue to roll forward into new bonds as the old ones mature. Hopefully interest rates continue to climb and we can get more income for our clients in the process.