Quarterly Commentary

Well That Was Fun, So What Do We Do Now?

Pop the champagne! 2017 was a great year with the S&P 500 up 21.58%. As far as I can tell, each of my clients made money last year. But you know, it’s funny and telling, the questions I get. At the end of 2008 when the stock market was down over 50% the questions were something on the order of, “Do you think this decline will ever end and will the stock market ever go up again?” Reverse that to year 2017 and do you know what questions I get now? They basically are, “Given how well the stock market did last year, do you think we are on the brink of another market crash?”

While no one can ever be certain of what the financial markets will do, my short answer to that question is, no. The last time I had conservative, elderly clients calling me to complain that they need to be more aggressive because their account is only up 28% in the last six weeks (I actually did get that exact call from a 68-year old retired client) was in February, 2000. . .five weeks before the peak of the 1990s’ “dot-com rally.” Once that starts happening to me again I will become more concerned. Until then my focus is on the fundamental data I see, and so here is what my research is telling me:

Stock markets rarely have back-to-back years with gains of 20% or more, but since 1925 it has happened eight times. So it could happen again. But it is almost non-existent to see a large decline after such a positive year. In fact, since that same 1925, the only year in which the stock market declined more than 10% after a 20% or better up year was 1937. Typically, years when the market is up 20% are more likely to be a precursor of good things to come rather than of impending economic disaster.   And there are a number of reasons why I believe this trend will continue.

In 2010, I, along with a friend of mine who was an analyst with Standard and Poor’s, performed a major historical study of the economic trends of businesses and consumers. One constant was that every recession since 1866 occurred after a significant buildup of debt, not the other way around.   Since the end of the 2008 “Global Financial Crisis” U.S. consumers have been consumed (pun intended) with paying down debt. Indeed, according to the Federal Reserve, the typical U.S. household has the lowest ratio of debt to their income since the early 1950s. The main reason we have experienced the slowest economic recovery in America’s history is because people have used their extra income to pay down debt rather than to spend. It’s hard to mathematically model an economic crisis with consumers in such a strong financial position, although I suppose there is a first time for everything.

The second reason is along the same thought line . . . except in regard to businesses. U.S. corporations appear to be in a similar financial position. According to the U.S. Federal Reserve, excluding banks, U.S. corporations have over $2.5-trillion in banks (most of that overseas).   Simultaneously, Federal Reserve data shows that eight years ago total corporate debt equaled 119% of our nation’s GDP. Today that debt ratio has dropped to only 91% of GDP. That is a whopping 28% improvement.

Again, it’s hard to forecast a major corporate catastrophe at the tail end of a doubling of cash and a ¼ reduction of relative debt.   That also would be a first time occurrence.

Concomitant with consumers being in their strongest financial position since the 1950s while US businesses have record amounts of cash and more reasonable amounts of relative debt, congress passes the largest corporate tax cut in our nation’s history. Ladies and gentlemen, in my estimation this is like seeing a campfire and dousing it with gasoline, and I don’t think the world has completely understood just how much this will mean.

Corporate tax rates on all income over $60,000 have gone from 35% to 21%. So if “Company A” earned $1-billion in U.S. profits they would have paid $350-million in taxes. Now they will only pay $210-million, which means they will have another $140-million.   Most financial analysts have simply added that tax savings to their earnings projections and left it at that. By itself that will add quite a bit to company earnings, but what hasn’t been calculated is what is known as “The Multiplier Effect,” which is analogous to my “gasoline on the fire.” What will Company A do with that $140-million? Maybe buy and upgrade their equipment. That will improve their profit margins going forward making them even more money. It will mean even more profits for the companies that make the equipment Company A buys. And more employees will be needed to make that equipment, meaning more workers will have more money to buy other things. Maybe they will increase wages to current workers (which they will do if all our businesses suddenly are competing for workers at the same time). More workers making more money will spend more money and invest more money.

And lastly, Company A may pay more dividends to current shareholders. I have heard many critics of the tax act saying that is what corporations will do and so (they say) there won’t be any economic benefit. That’s silly! What do you think shareholders will do with their increased dividends? They will either spend them or save them (in my experience they will do some of both).  These three scenarios don’t stop there. All the extra economic activities described above will repeat themselves, which will thereafter repeat again.

Interestingly, at the same time these tax cuts are occurring, the Trump administration is in the midst of cutting federal regulations. I can’t give you an accurate figure of how much our nation has spent on legal costs to adhere to the immense increase in government regulation since 2008, but by all accounts it is many of billions of dollars. Increased regulation has become so prolific that there are now examples of government agencies coming out with regulations that conflict with regulations created by other government agencies, making it impossible to obey the rules set by one without violating the rules set by another. If nothing else, a reduction in government regulation coupled with an administration who doesn’t see corporations making profits as an inherent obstacle to the prosperity of the common working man should result in a resumption of animal spirits in America’s board rooms. This should bring about a willingness for management to start spending the record amounts of cash they have already built up, not to mention the money they will have from any further economic expansion.

The last reason I believe the trend will continue is that America is not alone. When was the last time you heard that the world’s economy was going to collapse because Greece would implode, or the Spanish banks were going to crumble, or China’s economy would disintegrate from their collapsing real estate market, or any other possible economic crisis? It’s been quite some time. For the past nine years the rest of the world has been piecing together their economies from the 2008 crisis. They are now beginning to grow again. A stronger U.S. economy coupled with a stronger world economy is yet another arrow in the quiver.

Eventually all of this will peter out. But historically economic expansions peter out many years after excesses have been built up. Excess such as consumer debt reaching unsustainable levels, corporations having no room to borrow for expansion and no cash to cushion them from a downturn, and speculation replacing investment as the standard for what people do with their money (Bitcoin maybe? Well that’s a topic for another commentary).   Markets rarely go up or down in a straight line and this bull market has not seen more than a 3% pullback since November of 2016. We are well overdue for a 10% decline and I am convinced we will see one in 2018. If so I believe it would be an opportunity to invest more rather than a reason to sell. Does the 10% pullback begin now, or do we first rally another 11% or more before we see that pullback, making today’s highs the bargain prices of the next pullback?   No one knows the answer to that. But for now, my analysis shows the odds favor continued expansion in the economy as far as my eyes can see.

Joe Monaco

Ph.D. (economics)

President—Monaco Capital Management, LLC

Registered Principal—RJFS


Securities offered through Raymond James Financial Services, Inc., Member FINRA/SIPC. Monaco Capital Management, LLC is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment advisory services offered through Monaco Capital Management, LLC.   Information contained in this report does not purport to be a complete description of the developments refered to in this material. This information has been obtained from sources deemed to be reliable but its accuracy and completeness cannot but guaranteed. Opinions expressed are those of Joseph A. Monaco, PhD. Registered Principal, RJFS, and are not necessarily those of Raymond James.

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