Risks to the US Stock Market Rally in 2018 – “What Could Possibly Go Wrong?”

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By Terry Connelly, Dean Emeritus of the Ageno School of Business 

terry-connelly

It was hard NOT to make money in the American stock market because almost everything went right in 2017, with each of the DOW the NASDAQ and the S&P 500 indices up between 20% on up to 28%. Yet some Wall Street traders managed to fail against those benchmarks or even lose a lot of money, largely by shorting high-growth technology, going long energy or otherwise trying to live without the moderate to high price day-to-day price volatility that is the mother’s milk for trading profits. Investors who simply invested in those indexes did very well indeed: $1000 spent buying the S&P 500 index, for example, yielded a total of $200+ in profits by the last day of trading in 2017.

But even with such performance, the US market was surpassed by the returns of its global peers, as measured by the MSCI ACWI non-US Index that tracks non-US companies across other developed and emerging markets. According to CNN Money, Hong Kong’s Index was up 36%, India’s 28% and markets in countries coming out of the shadows of economic downturns like Argentina (77%) and Nigeria (42%) were also up substantially more than the US market.

Last Days of 2017

Indeed, the synchronized global recovery in 2017 – including Europe (with or without the UK), plus India, Japan and many developing markets (but excluding China) – was fueled by maintenance of relatively low interest rates and bond buying by major central banks including the US Federal Reserve and the European and Japanese Central Banks. This had a lot to do with the US stock rally – perhaps even more than the self-described hero of equities President Donald Trump. In fairness, his election obviously had a positive impact on stock values – investors quickly and accurately saw him and his Administration’s agenda as very favorable to American business interests. As a “discounting mechanism” for future economic value, the stock market anticipated his tax cut agenda increasingly as it became finally clear that it would pass in the late fourth quarter and rose 25% for the year.

Investors generally know about the risks of a North Korean nuclear conflagration and the Mueller investigation of possible Trump campaign ties with Russia…But there are other less-noted risks that merit attention.

Nothing in fact of substance to the equity market has changed between December 29, 2017 and the first week of January 2018 so many analysts have predicted a continuing positive run for stocks in the New Year. Yes, there was a 100+ point drop in the Dow the last minutes of trading that coincided with a last-minute headline on Reuters that Russian ships were secretly transferring oil on the high seas — in violation of UN sanctions — to North Korean vessels. But Russia denied any “State” involvement (just as China had done days before in response to a similar charge).

Diplomatic Relations in 2018

Denials aside, however, US relations with Russia, China, North Korea (and even oil) pose risks to the US stock rally that investors need to take into consideration as they count especially their unrealized winnings – as they also contemplate their moves under the new tax regime, which has lowered individual rates such that the 24% personal rate kicks in only when couples’ taxable incomes reach $315,000 while long-term capital gains rates for such folks still come in at 23.8%. This marginal effect is a whole new wrinkle in a tax code change that otherwise is far more favorable to capital than salaried income! The tax changes themselves also include some surprising potential pitfalls for investors as the year begins, as we shall see below.

New Market Risks that Merit Attention

Knowing “when to hold ’em and when to fold ‘em” is a skill often in demand and frequently in short supply. Investors generally know about the risks of a North Korean nuclear conflagration and the Mueller investigation of possible Trump campaign ties with Russia that could threaten impeachment and political turmoil. Thus far markets have not reacted adversely to these threats, nor to China’s relative economic slowdown in the wake of financial reforms and capital controls.

But there are other less-noted risks that merit attention. Let’s uncover some of those:

Trade War

A trade war with China has often been threatened by Trump, but no trigger has been pulled as yet — although there have been media reports that an Administration squeeze on China trade is coming as early as January. We know from the Depression onward that markets hate trade wars, especially right when the world economy, driven by trade, is just starting to come around.

Interest Rates

The price of oil has been recovering from a multi-year slump and closed the year above $60, along with the increasing price of other commodities in part due to the 7.5% decrease in the value of the US dollar in 2017. Such inflationary pressure could lead the US Fed to raise interest rates more quickly than anticipated now by the market. That outcome could be negative for US equities even if US GDP picks up to near 4% as Trump predicts.

[The] tax code change … is far more favorable to capital than salaried income! The tax changes themselves also include some surprising potential pitfalls for investors as the year begins…

Government Shutdown

Likewise, the Federal government’s unfinished budget business (which took second place to passage of the Trump tax bill) is now leading to a January 19 shutdown deadline that could also play havoc with equity values short-term — especially if both Trump and the Democrats conclude that a shutdown fight over “principles” is in their 2018 midterm election interest. Remember that politicians take credit for rising stock values, but blame “market forces” for corrections and crashes.

Corporate Tax Rates

Under the new tax “repatriation” provisions, US corporations holding cash profits at least technically offshore to income tax liability here are deemed to have repatriated that cash effective in the 2018 tax year and owe theirs in addition to the new special tax of 15% on those proceeds. Although they can spread the payment that tax amount over 8 years, many will follow the lead of Goldman Sachs and take a charge for that liability in their last quarter of 2017, creating a sharp decline or even negative result for quarterly profits – quite the opposite of the strong and steady increase in such profits investors had come to appreciate and value in 2017!

Will shareholders look past this one-time hit to the fact that the new tax regime severely limits taxation of foreign profits of US companies going forward with a new “territorial” based-regime more akin to the rest of developed world? That risk question starts coming up right now. Goldman’s stock closed 1% down after its decision was announced on the last day of US trading, in a reversal of a recent uptrend that had broken above long-term “resistance” levels.

Banks

We will also need to see what other banks do with write-offs of tax-loss carry-overs from the bad days of the financial meltdown beginning in 2007, which are now worth much less on their balance sheets than they were before the new tax law substantially cut their effective tax rates from the mid-thirties to nearly the teens. A knee-jerk “run” on bank stocks could also upset the equity market’s equilibrium early in the first quarter as last quarter charges hit.

Technology Stocks

Another sector that has been responsible for much of the equity indices march higher has been technology, especially the “FANG” stocks – Facebook, Apple (and/or Amazon), Netflix and Google (now officially “Alphabet). The risks here to investors are even more substantial and longer term.

Senator Mark Warner and others in Congress have targeted Facebook’s and other Silicon Valley giants’ failures to control Russian use of its platforms to spread fake news intended to interfere with US elections.

Apple ended the year with an apology for remotely and secretly controlling the internet access speed of older iPhones to save battery life. This is a worthy goal, for sure, but an unworthy process that ironically mocks the very same “net neutrality” policies – now overturned by the Trump’s appointed leader of the FCC – which other FANGS and, lately, Apple have so vigorously has advocated.

In addition, Amazon is in Trump’s sights most recently for its “cheap” delivery deal with the US Post Office. Netflix has its own problems with new direct competition from Disney and its combination with Fox Entertainment – not to mention its ongoing streaming rivalry with Amazon. And Google is under threat from the European Union for billions in fines and more for favoring its own brands on its search function.

Collectively, the FANG stocks spell more risks for investors even than individually, because their rising stock prices have along with other “tech” companies has elevated their percentage presence of that sector in “market-cap-weighted” indices like the S&P 500. If the market turns sour on a set of such tech stocks, it would bring down the value of the whole index accordingly. Thus the 20% profit enjoyed by S&P index investors in 2017 could quickly turn the other way if the FANGS collectively fail to deal effectively with their current challenges.

The Dow and Its Most Expensive Stocks

The Dow Industrial average, by contrast, is not market-cap-weighted but stock-price weighted – so that that it is the higher per-share price stocks like Goldman Sachs (and, Boeing, IBM, and Apple) can have outsized impact day to day. As noted, some of these companies have their own special risks going into 2018 and can bring down the Dow index if they are not handled well.

The best speech I ever heard on Wall Street, given to assembled investment bankers in the midst of a trading recession, was the simple “environ­mental” reminder that “trees don’t grow to the sky.” Even as the science of climate change undergoes severe challenge from the “fake news” crowd, 2018 investors would do well to remember that basic lesson of ecology.


About Terry Connelly

Terry Connelly is an economic expert and Dean Emeritus of the Ageno School of Business at Golden Gate University. With more than 30 years experience in investment banking, law and corporate strategy on Wall Street and abroad, Terry analyses the impact of government politics and policies on local, national and international economies, examining the interaction of global financial markets, the U.S. banking industry (and all of its regulatory agencies), the Federal Reserve, domestic employment levels and consumer reactions to the changing economic tides. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore (corporate, securities and litigation practice in New York and London), global chief of staff at Salomon Brothers investment banking firm and Cowen & Company’s investments, where he served as CEO. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education (2011). Riptidedeconstructs the changing landscape of higher education in the face of the for-profit debacle, graduation gridlock, and staggering student debt, and asserts a new, sustainable model for progress. Terry is a board member of the Public Religion Research Institute, a Washington, DC think tank and polling organization, and the Cardiac Therapy Foundation in Palo Alto, California. Terry lives in Palo Alto with his wife.


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