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The stock market had a strong 2017, supported by strong corporate earnings, healthy economic growth, and the prospect of US tax cuts.
The tax reform passed in December has brought an already overbought stock market to nosebleed valuations. Under the new tax law, corporate tax rates have just fallen from 35 percent to 21 percent,
and foreign cash can be repatriated at a 15.5% rate. This is unquestionably good for stocks as these tax cuts go directly to the bottom line of businesses. The question is, to what extent is the tax reform already built into the market?

On a cyclically adjusted basis, the price per share of stocks relative to average earnings from the previous 10 years is at its highest level of the past century, other than during the dot-com era. In fact, it is nearly 95% higher than its arithmetic mean. The S&P 500 is 117% higher than its historical trendline.
The behavior of the stock market has been exuberant, but will the new Federal Reserve Chairman Jay Powell, who takes office in March, “take away the punch bowl” just as the party gets going? Valuations across all asset classes are excessive and dangerous, particularly in stocks. Complacency in the stock market, as measured by the VIX index, is trading at or near all-time lows.
One little noticed occurrence that took place toward the end of last year is the “output gap” closed in the United States for the first time in ten years, meaning that the economy is operating now at full capacity. And yet, the Fed has never been so accommodative at this point in a business cycle in its history. While the Fed has announced that they will raise interest three times in 2018, the market is still only pricing in two times. Some Wall Street analysts are predicting four. The final number outcome of course will depend on expectations over inflation. If past is prologue, the history of new Fed chairmen demonstrates that tend to they over-tighten interest rates in the beginning of their tenure. This was the case with Paul Volcker in 1979, Alan Greenspan in 1987, and Ben Bernanke in 2006. While Janet Yellen has proven to be very supportive of asset prices, Mr. Powell has been quoted as saying: “it is not the Fed’s job to stop people from losing…money”.
The Underlying Inflation Gauge (UIG), is a statistic published by the Federal Reserve Bank of New York, which is a member bank of the Federal Reserve System. There tends to be an 18 month lag between this inflation indicator and the actual CPI indicator. The UIG is now at 2.95%, and is moving up. This makes sense because we are at full employment in the U.S. and wage inflation may begin to appear soon, despite the deflationary impacts of robotics, globalization, demographics, and ever increasing debt servicing costs. Because of this, it is likely that the Federal Reserve continues to raise interest rates as announced.
January marks the real start of the Fed’s ambition to reverse the economic stimulus they have provided for the past ten years. They have ended their program of buying assets with printed money, and will now reverse this by shrinking their balance sheet by $50 billion per month going forward. That means that that when bonds that they have purchased in the past mature, they will not be repurchasing more of them.
It should be noted that Janet Yellen is replaced by Jerome Powell, a Trump nominee, there will still be four Governor seats out of seven at the Fed which are empty. The now relatively inexperienced Fed will be dismantling the Fed’s balance sheet without the knowledge and experience that the Fed usually has in place. The European Central Bank is set to announce a new president, most likely a German one, meaning a higher likelihood of higher interest rates in Europe as well. The Bank of England and the Bank of Canada have already joined the U.S. in raising interest rates.
During historically overvalued times like these, there could be more upside to this bull market which represents a final “blowoff”. A “QE”, or stimulus driven market is bound to overshoot, and could do so further, which is frustrating for anyone with a disciplined approach to investing.
A wealth advisor has two options keeping in mind hi Fiduciary duty to clients:
• Either avoid the last phase of the bull market altogether, or,
• Put stop losses in place. Stop losses are sell orders that will limit losses to a predetermined percentage if the market takes a downward turn.

Given the equally historic levels of complacency, love can turn to regret quite quickly. One is far better advised to take gains right now than further invest.

For 2017, the S&P 500 was up 19.4%, and the Dow was up 25%.

Grant Rogers

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