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About That 22%

Adam M. Grossman  |  January 17, 2018

THE STOCK MARKET had a great 2017, gaining more than 20%. But was that kind of gain justified—or should it worry us, especially after the market had already tripled in recent years? I think it’s useful to understand the range of viewpoints, so we’re better prepared for 2018 and beyond. Here are the bull and bear cases:

Bull Case. As measured by the S&P 500 index, the U.S. market gained nearly 22% last year. While this may seem like a lot, you can argue that it makes perfect sense. At the end of December, Congress overhauled our tax system, reducing the corporate tax rate from 35% to 21%.

To understand how this might affect stock prices, let’s look at a simplified example. Suppose ABC Corp. earned a $100 profit last year and expects to earn another $100 this year. In 2017, under the old rules, the company’s tax bill would have been 35%, or $35, leaving it with after-tax income of $65. This year, under the new law, this same company’s tax bill will be just 21%, or $21, making its after-tax income $79.

If you do the math, you’ll notice that this profit increase, from $65 in 2017 to $79 in 2018, works out to roughly 22%. That is virtually identical to the stock market’s gain last year. Bulls would thus argue that last year’s rally was entirely rational: If a company’s profits increase 22%, its stock price should also appreciate 22%.

Bear Case. The bear case starts by noting that there is a fair amount of coincidence in these two 22% numbers. Yes, I do believe the market rose in anticipation of tax cuts. But the math isn’t as simple as I made it out to be.

Even under the old regime, only a minority of companies paid the statutory 35% rate. Last year, for example, Apple paid just 25%, Alphabet (a.k.a. Google) paid 22% and General Electric paid no tax at all. Moreover, at an individual company level, there was no relationship between the size of the tax cut and the size of the stock move.

On top of that, a change to U.S. corporate tax rates doesn’t explain why last year an index of emerging markets stocks—including Brazil, Russia and China—rose nearly 40%. Those countries didn’t benefit from our tax cuts.

Finally, an objective measure of the market points to significant overvaluation. Bob Shiller, a Yale professor with a better-than-average track record predicting economic cycles, maintains a measure called the cyclically adjusted price-earnings ratio, or CAPE, and it doesn’t look good.

Right now, it’s higher than it was in 1929, just before the Great Depression. Look online and you’ll quickly turn up headlines like this: “The ‘CAPE To Saving Rate’ Ratio Signals A Terrible 2018 For U.S. Stocks.”

Where does this leave us? As a former colleague used to say, it’s all “clear as mud.” While that conclusion might seem unsatisfying, I think it teaches us two important realities about the stock market.

First, there is no one universal measure of value. Yes, there are some dire headlines about the CAPE Ratio, but opinions do differ. You can also find headlines like this: “Why the Shiller CAPE Ratio Is Misleading Right Now” and “CAPE Has a Dismal Record as Predictor of Stock Performance.”

In other words, reasonable people disagree, no one can say with scientific certainty that the market is overvalued, and none of us knows what will happen next to share prices. The most important thing for your investments: Be sure you aren’t dependent on a stable or rising stock market to meet your upcoming living expenses. If you worry that you are, you should immediately revisit your portfolio’s asset allocation—your mix of stocks and more conservative investments.

Second reality: Markets are forward-looking. Wall Street is staffed by armies of investment analysts who track every development that could possibly impact the market. In an effort to get ahead of each other, they usually start placing their bets well in advance of important events. That’s why the market started to turn around early in 2009, for example, even while unemployment was still rising. Traders were looking ahead.

Similarly, I believe this is what happened last year, in advance of the tax cuts. This is not to say that 2018 won’t see stock market gains. But it’s important to recognize that professional investors are always looking forward and will react well in advance of whatever they see coming next. Do you rely on regular withdrawals from your portfolio to cover your living costs? This is another reason it’s vital to have an asset allocation that provides protection against future, unexpected events.

Adam M. Grossman’s previous blogs include More for Your Money, First Things First and Grossman’s Eleven. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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