Stocks close modestly higher as Congress passes tax reform

While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster. – Benjamin Graham

Despite a wealth of news and economic data last week that was mostly positive, the three major stock averages closed only modestly higher. For the Dow Jones Industrial Average and the S&P 500 Index, it was the fifth consecutive week that these two benchmarks closed higher. In the process, the Dow posted its 70^th record close of the year, which was the highest number of record closes in a year. The Nasdaq Composite Index also joined the party by briefly trading over 7,000 before falling and ending the week below this threshold. It was a week filled with merger announcements, too, as Campbell Soup, Hershey and Oracle all announced plans to acquire smaller companies. There also was a slew of housing data released last week and all of it was favorable, providing a strong underpinning for the economy. But the biggest news item of the week was passage of tax reform by Congress and the signing of the bill on Friday by President Trump. The bill slashes the corporate tax rate from 35% to 21% and lowers rates for individuals, all of which could boost S&P 500 earnings next year by 5%. Congress also avoided a government shutdown on Friday by passing a bill to keep the government funded through January 19^th. With so much good news, one would have expected the stock market to perform even better. However, most of the perceived benefits of tax reform and their positive effect on corporate earnings had already been priced into the market. As early as mid-November, stocks began rallying in anticipation of tax reform becoming a reality and during that time, the S&P 500 has risen nearly 5%. All of this good news was not lost on the yield of the 10-year Treasury, though, as it rose to about 2.5% by week’s end. While stronger economic growth and increased consumer and capital spending may be byproducts of lower tax rates, they also will probably lead to higher interest rates in the future.

Last Week

Housing data dominated the economic reports last week and all of it was positive. Homebuilder confidence hit its highest level in 18 years in December and housing starts in November were higher than in October and 13% higher than a year ago. Existing home sales in November were also better than expected and reached an 11-year high while November new home sales rose to a 10-year high. Leading economic indicators for November rose modestly and were in line with estimates while the final reading of third quarter GDP was 3.2%, slightly lower than the initial reading. Nevertheless, consumer spending still remained strong. On a disappointing note, November durable goods orders were less than expected and weekly jobless claims came in higher than expected, although layoffs still remain low.

For the week, the Dow Jones Industrial Average rose 0.4% to close at 24,754 while the S&P 500 Index gained 0.3% to close at 2,683. The Nasdaq Composite Index also added 0.3% to close at 6,959.

This Week

This week will be a quiet one for economic data as December consumer confidence is forecast to remain elevated and the December Chicago Purchasing Manager’s Index (PMI) is expected to remain above 60, a reading that indicates strong expansion.

The stock market will be open all day on Friday but the fixed income markets will close early ahead of New Year’s Day on Monday.

It will also be a quiet week on the earnings front as there are no scheduled corporate earnings reports.

Portfolio Strategy

With economic growth poised to accelerate and inflation expected to rise as wages increase, it may be time for value stocks to outperform growth stocks. Growth stocks, which tend to have higher price earnings ratios, lower dividend yields and above-average, consistent earnings growth, have outpaced value stocks since the end of the financial crisis. While it appeared that value stocks would begin to beat growth stocks near the end of 2016, they faltered and growth stocks have emerged as the clear winners in 2017. But value stocks, which have lower price earnings ratios, higher dividend yields and lower book values, tend to perform better during periods of stronger economic growth and higher inflation expectations. Growth has already begun to pick up and the recently passed tax reform legislation should only augment economic growth. Stronger growth coupled with a tight labor market could lead to higher wages and an expectation of higher inflation. In fact, the Federal Reserve has already indicated that it plans to increase interest rates three times in 2018 in order to normalize monetary policy and combat rising inflation. If such a scenario plays out, there could be a rotation by investors out of high-priced growth stocks and into cheaper value stocks. The past few weeks have seen the Russell 1000 Value Index outperform the Russell 1000 Growth Index and that trend could continue into and through the New Year.