20 July 2019
US equities are well on track to continue last year's trends, at least for now. Photo: Reuters
US equities are well on track to continue last year's trends, at least for now. Photo: Reuters

Divergences dent a spectacular year

You’d think, listening to media, that stocks are rising with great uniformity, that, as the old saying goes, a rising tide lifts all boats. But when you dig below the surface a bit, you’ll see that that isn’t really the case. In fact, wide divergences had appeared in the market late in 2017.

The dispersion between the best- and worst-performing sectors in the S&P 500 Index since the beginning of last year has been eye-popping. In 2017 the performance of the tech sector nearly doubled that of the broad index, gaining 41 percent on a total return basis versus around 22 percent for the index as a whole (as of Dec. 20), a truly astonishing figure.

Even more astonishing is the spread between the best- and worst-performing sectors, with the telecom and energy sectors each underperforming tech by about 45 percent and the index as a whole by more than 25 percent.

So clearly, not all ships are rising at anywhere near the same pace, and some are even sinking a bit.

Divergences of this sort have happened in the past, and in the case of the energy sector, it sometimes has been a harbinger of a downturn in the price of crude oil. In past instances, this coincided with a stronger dollar and broad commodity price weakness which has contributed to downward pressure on earnings for the overall S&P 500 Index, so we view the energy sector divergence in 2017 as a warning sign for 2018.

My tax take

Here’s my two cents on the impact of the new US tax legislation. The tax reform will impact large-cap companies differently. For instance, domestic-facing companies will tend to experience a big drop in effective tax rates which should boost operating earnings on the order of 8-10 percent over the previous year, all else being equal.

However, the high-flying tech sector, with its heavy overseas sales, pays an effective tax rate, on average, of about 19-20 percent, close to the new statutory rate of 21 percent. So it is unlikely to be helped as much as some optimists are predicting.

Under the new tax law, highly-indebted companies could end up worse off, as they will not be able to deduct interest expense above 30 percent of their cash flow. Companies with large research and development budgets, such as pharmaceutical companies, and big capital goods manufacturers are likely to benefit from the immediate expensing of short-lived capital investments.

Overall, the law is generally beneficial for large-cap US companies, but not in equal measure. Your mileage may vary.

It’s my view that the new tax legislation won’t lift all stocks immediately or in a lasting fashion. I would not use the approval of the package as justification to blindly purchase baskets of stocks. The devil is in the detail and those ramifications need to be analyzed.

I also believe that the solid global economic growth we’re seeing today doesn’t benefit all markets. The undercurrents are dramatic and may carry messages. For example, they imply that future growth may not be as strong as that which we’re seeing today.

The higher the market rises, the bigger the risk that complacency supersedes scrutiny. Ignoring fundamentals and valuations has the potential to trip up unwary investors. The traps are there; we’ve seen episodes like this before.

This is all the more reason for investors to tread lightly and deliberately into non-selective packages of expensive financial assets.

– Contact us at [email protected]


The author is Chief Investment Strategist at Massachusetts Financial Services

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