,

The Brave Report: Market Commentary for December 2017

Click Here for PDF version of this report: The Brave Report-Dec 2017

Santa came early this year. We have all heard the term “Santa Clause Rally” before but this year we have seen a “Turkey Clause Rally.”  All major indices have been on quite a run since before Thanksgiving and have continued to post new all-time highs.  The end of the year is always an interesting stretch, especially in years that most stocks have seen substantial gains.  Will investors take profit or will they let these gains ride into the New Year? With few losses in investor portfolios, there are not many losses to harvest this year and thus any sales would result in taxable sales. Throw on top of this the prospect of the new tax bill being signed into law in the coming days and there is very little selling pressure on the market.

Market Overview

Over the past month, all three major indices have taken major steps forward.  The Dow Jones Industrials led the way gaining more than 5%.  The S&P500 and the NASDAQ followed close behind, gaining around 4% and 2.5% respectively.

This performance dynamic is a bit of a change from what we have seen in recent months, with the more tech-heavy NASDAQ trailing the other indices instead of leading the day.  This is primarily due to some profit taking in some high flying tech names when details of the new tax bill began to leak out.  There was a worry that the way certain capital gains would be calculated was going to change.  This has subsequently been removed from the current bill and we have seen most of tech recover accordingly. But this brief sell-off was enough to mute some of the index’s gains for the month.

On the fixed income side, rates have been pretty stable considering the Fed raised rates last week.  This increase was widely expected so was mostly priced in.  The 10-year traded in a pretty narrow range from a yield 2.32 to 2.42, only jumping above 2.42 on Tuesday, December 19th. This also concludes the narrows trading range the 10-year has seen over the course of a year since 1965, trading in just a 50 basis point band all year.  With the Fed seemingly sticking to its planned rate increases there have not been a lot of shocks to the system. With that said, we are about to see a number of new fed governors so it will be important to monitor how their opinions differ from current members.

Tax Reform: Tax reform has been hanging over these markets since the election, with the markets seemingly pricing in a massive corporate tax reduction for the last 12 months. Well, all the speculation, negotiation and political wrangling finally yielded a result.  On Wednesday, both the Senate and the House finally passed some of the most sweeping tax reform in years. We are analyzing the final bill and only time will tell how effective the new reforms will be in reducing taxes but at first blush, this looks like a huge win for corporations.  How these corporate benefits will impact the economy and more importantly the individual taxpayer will now be the big questions moving forward.

This is not the venue to do a deep dive into the entire bill but I will go through a few of the basic highlights. The big change on the corporate side is the reduction of the corporate tax rate to 21%.  This is a huge reduction and puts us better in line with other developed countries.  This change is permanent, whereas many of the individual tax reforms are set to sunset in ten years. In addition to this decrease in rates, there is also an adjustment in how pass-through entities are dealt with.  This could definitely change how many small and mid-sized businesses operate, especially in the classification of employees as outside contractors vs. employees

On the individual side, the standard deduction was doubled.  This will cause fewer people to itemize their deductions but,  for those that still do, there will be some tradeoffs. There was a reduction in a number of personal deductions.  There is now a cap on the deduction of state and local tax of $10,000.  The mortgage interest deduction was also capped at mortgages with a principle of under $750,000. Along with these adjustments to the various deductions tax rates were trimmed across the board.

There was speculation that the estate tax would be repealed as part of this reform but instead, the bill just doubles the estate and gift tax exemption to $11.2 million per individual.

These are just a few of the many tax changes that investors should be aware of going into 2018.  This is not an exhaustive list, by any means, but hopefully touches on some of the more important ones.  I encourage everyone to speak with their advisor or accountant to understand how these changes may impact you.

The big question moving forward is will these cuts have a positive impact on the economy.  In the short term, I worry that many of these cuts are already priced into the markets and are partially responsible for the market gains we have seen since the election and now that the bill is passed we could see some selling on the news. However, if these cuts do as intended and stimulate growth within the economy this could set the stage for a continuation of the bull market we have been in for the past nine years.

Rate Hike: As was widely expected and completely priced in, the Fed raised rates by a quarter point last week. They did not adjust any of the projections for the next year, reiterating the expectation of 3 rate hikes next year.  The interesting part of this month’s meeting wasn’t that they increased rates.  Last week’s meeting represented Janet Yellen’s last as the chairman of the Fed. Trump nominee, Jerome Powell, will take over chairman duties early next year. In addition, due to a number of resignations and terms ending, Trump will have the ability to nominate a number of new members.  While widespread changes in Fed policy are not expected, additional uncertainty around the future of the Fed could unnerve markets should the new members deviate much from the plan that Yellen and the other voting members have laid out for the next year. Even with few imminent policy changes, it will be worth watching how Chairman Powel transitions to his new role.

Strategy Commentary

I continue to maintain a slightly reduced equity allocation. While I have missed out slightly on the run the market has been on in the last month or two I have been comfortable with my allocation.  The uncertainties around tax reform have been casting a cloud over the markets. However, with tax reform now a reality, I will be looking to increase my equity exposure.  Earnings season confirmed solid fundamentals across the market and with the removal of one of the bigger uncertainties the market has seen in a while the markets till should have some room to run.

Domestically, I shifted out of Healthcare and into Financials. While financials have been on a tear over the last six months.  The increasing rate environment and the completion of tax reforms should be a catalyst for financials to continue their advance. Although tech saw a brief hiccup early in the month it still represents the best opportunity for growth in the coming months. I also increased my allocation to mid-cap growth.

Internationally, I continue to maintain my overweight to emerging markets. I see it as the best place for growth moving forward.  I also reduced my allocation to developed international equities.  There is more uncertainty surrounding the European Union and the plan for Brexit and I would rather stay on the sidelines for now.

I am still negative on the fixed income space. Rates continue to trend higher and with three rate hikes expected next year, I would rather stay underweight at this time