Key Points

  • Global growth and earnings have been the market’s drivers; but tax reform has represented a more recent kicker.

  • Could we be setting up a “buy the rumor, sell the news” environment, especially if earnings forecasts don’t deliver?

  • Stocks, especially large caps, actually do well as the yield curve flattens.

Perhaps it’s premature (or even a jinx) to mention that if the S&P 500 ends December in the green, it will be the first time in history that U.S. stocks—as measured by that index—were up during every one of the 12 months. The only other year that came close was 1995, which saw a tiny drop of 0.4% in October. Incidentally, this year is most highly correlated to 1995 of all years since the S&P 500’s inception, according to Bespoke Investment Group (BIG). For what it’s worth, 1995 was followed by another strong year in 1996—up 23% for the S&P 500.

Growth the driver; tax reform the kicker

Two of the most important drivers of stocks’ ascent this year were synchronized global growth and strong corporate earnings. The prospects for tax reform have been a more recent kicker—and also the proximate cause for the sharper sector rotations we’ve seen lately. Following September’s tax reform hope-fueled surge, investors have been doing more homework with regard to the prospective winners and losers at the corporate level—rewarding those companies and industries which sit at the highest end of the effective tax rate spectrum.

In September, investors’ somewhat knee-jerk reaction to elevated expectations for tax reform was to buy up small-cap stocks—believing they were generally bigger beneficiaries (not necessarily the case). Since then though, small caps have experienced renewed underperformance as investors have been doing more precise homework on tax reform’s winners and losers. We are maintaining our bias toward large caps over small caps given the valuation premium at which the latter are still trading. In my mind, it begs the question of why investors would want to pay a premium for a weaker earnings profile. You can see distinctly weaker earnings growth as you move down the cap spectrum in the table below.


Source: The Leuthold Group.

Earnings boost ahead?

The data above is for earnings already in the book. As we have noted throughout the year, the vast majority of analysts and/or economists have not yet incorporated tax reform into either their corporate earnings or gross domestic product (GDP) forecasts. As such, one could claim that the best is yet to come as estimates for 2018 have yet to be adjusted upward. I don’t want to pull the punch bowl away before the year-end partying has even begun, but some detail is warranted.