Major stock averages close at record highs on tax reform news

The only time to buy that which you don’t understand is on the day with no Y in it. – Warren Buffett

All three of the major stock averages closed at record highs last week as the odds that the Republicans would pass a tax reform package increased substantially. While there was some doubt as to whether or not the Republicans had enough votes after Senator Marco Rubio argued that the child tax credit should be larger, his wish was granted by Friday and stocks rallied on the news. With a cut in the corporate tax rate to 21% and reductions in individual tax rates as well, investors became convinced that this legislation will boost earnings growth in 2018. Continued efforts by the Trump administration to eliminate burdensome and unnecessary government regulations should also help increase corporate profitability. Confident now that they have enough votes to pass tax reform, Republican leaders hope to vote on the bill this week and have it on President Trump’s desk for his signature by Christmas. Stocks have risen on the hope for tax reform and could fall when it actually becomes a reality as investors sell on the news, but most investment strategists believe that the tax plan will lead to more upside in the stock market. Almost forgotten last week with the focus on tax reform was the Federal Open Market Committee (FOMC) meeting. As expected, the Fed raised its benchmark interest rate a quarter point to a target range of 1.25% to 1.50%. This was the third quarter point increase this year and three more similar hikes are planned for 2018. Fed members also raised their estimate slightly for GDP growth and inflation next year and expect that the unemployment rate will dip below 4% in 2018. Overall, the Fed remained optimistic about the economy and forecast that the labor market will remain strong. Even outgoing Fed Chair Janet Yellen conceded that the possibility of tax cuts and tax reform was helping to boost the economic growth outlook. The announcement last week that Walt Disney agreed to buy 21^st Century Fox’s movie studios and other assets for $52.4 billion also helped give the stock market a lift as investors believed more deals could be on the way.

Last Week

Inflation data released last week was generally higher than expected due to the increased price of gasoline. The producer price index (PPI) for November posted the biggest monthly gain in 6 years while the consumer price index (CPI) and U.S. import prices were also higher than in October as gas prices surged. However, core CPI, which excludes food and energy, rose only 1.7% for the year ending in November and the personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, has also been running below 2%, the Fed’s targeted rate for inflation. Retail sales in November were much higher than expected, and as a result, it appears that the economy is poised to gain strength. Weekly jobless claims fell 11,000 to 225,000, less than the 239,000 that were expected, as the labor market remains strong and November industrial production rose modestly as expected.

For the week, the Dow Jones Industrial Average rose 1.3% to close at 24,651 while the S&P 500 Index added 0.9% to close at 2,675. The Nasdaq Composite Index jumped 1.4% to close at 6,936.

This Week

November housing starts, existing home sales and new home sales should all show numbers that are consistent with a healthy housing market. The final reading of third quarter GDP is expected to remain unchanged at 3.3%. Durable goods orders for November are forecast to show a big increase due to a rebound in civilian aircraft orders but leading economic indicators are expected to show only a modest increase after a strong October.

The U.S. government could face a partial shutdown if Congress does not pass a funding bill on Friday.

The most notable companies that are scheduled to report earnings this week include Carnival, Darden Restaurants, Micron Technology, FedEx, General Mills, Nike, Accenture and Con Agra Brands.

Portfolio Strategy

The late legendary investor, Sir John Templeton, once said that “bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria”. Right now the stock market is in a stage of optimism as investors are confident about the economy and future earnings growth, believe inflation is under control, are sanguine about the jobs market and hopeful that tax reform will solidify economic growth. Since it bottomed back in March 2009, the stock market has had a remarkable run with the S&P 500 posting a total return of nearly 400%. However, valuations are now stretched as this benchmark currently trades at about 22 times trailing earnings, compared to the historical average of about 15 or 16. Based on earnings estimates for 2018, the stock market trades at about 18 times expected profits, still not cheap. On an absolute basis, the stock market is very expensive. But relative to current bond yields, stocks are not nearly as overvalued as they may appear. The earnings yield of the S&P 500 Index, which is the inverse of the price earnings ratio, is about 4.5%, which is almost double the current yield of 2.35% on the 10-year Treasury. Not only are earnings expected to grow by about 10% next year, but the effects of tax cuts have not been figured in and should mean even higher profit growth. While stocks may not be cheap, they are not in bubble territory, either, as many pundits have been quick to point out. There are no visible signs of euphoria, at least not yet, and until there are, this bull market could continue to move higher.