Based on the weekend news reports, one would think that we are going into a bear market after the almost 4% drop in the S&P 500 Index last week.
Now, after that drop, the financial news commentators are talking about the risk in the market. Where were their concerns on Friday, January 26, when the S&P 500 closed at a record high? In retrospect, the risk was actually higher then.
The market as measured by the S&P 500 at the close on January 26 was up over 7% since the beginning of the year. Since the night of Trump’s surprise victory in the November 2016 election, the market is up almost 38%. The biggest correction in the time since Trump was elected was about 3%.
If you look at history, markets do not usually go straight up. When they do, the inevitable correction is put off. When the correction happens, it is usually sharper and more violent than it would have been if the market had not been so overextended before a correction occurred.
The time to warn about the risk in the market was in the last half of January. The correction that started last week and scared the financial commentators on Friday only gave back a bit over half of the gain for the month of January. In terms of the market rise since Trump was elected fifteen months ago, the market has only given back 5% of the gain.
Periodic market drops are part of being an investor. For those who keep their emotions in check, they represent an opportunity to buy stocks at a discount. Of course, this means you would have been wise to book some profits as the market was going up and up again.
Looking at the last 20 years, the market has corrected multiple times. Most of these corrections were relatively modest, less than 10%. The exception was the bear market of 2008-2009. This market drop was roughly 50%.
So, what is the difference between a correction that is actually a buying opportunity and one that is the start of a bear market?
The answer is simple. Bear markets nearly always mark the beginning of a recession or an economic slowdown. So, the proper question about deciding whether to stay in the market and potentially add to positions is to examine whether or not we are going into a recession.
Recessions are defined as a contraction of economic growth. The recent stock market rise has been fueled by optimism about the economy. This optimism has been fueled by Trump’s reduction of intrusive government regulations on business and by the passage of the tax cut.
The impact on the economy from tax cuts in the short term – defined as one to three years – is nearly always positive. This means that there is a strong likelihood that the tax reductions will improve economic growth over the next one to three years.
As an aside, the new tax cuts will add to the deficit at least until economic growth increases, which it surely will. However, American citizens and investors have shown through the years that they are only concerned about the long-term deficit at coffee shops and cocktail parties. When they vote or when they invest, it is a problem that they ignore.
With the impact of the tax cut and its contribution to economic growth, it is highly unlikely that we are going to have a recession any time soon. This means that the current market dip is a correction and an opportunity to buy stocks at lower prices.
Since the tax legislation was passed, several people have asked me what I think about it.
The bottom-line is that it is good legislation. It certainly was not tax simplification as it was labeled by the politicians. But the tax cuts will be good for the economy because they will promote economic growth.
Lower tax rates for businesses will lead to more investment and more jobs. They will also enable many large corporations to bring profits from their overseas operations back to the USA because our corporate tax rate is now low compared to world-wide corporate tax rates. It will increase investment in the US which will lead to more and better jobs and higher wages.
The tax cuts are also good for almost all individuals. The exception is people who own a large home or a vacation home or live in a state with high state and local taxes. The tax plan limits deductions for sales and property taxes to a maximum of $10,000. The mortgage industry deduction is limited to mortgages less than $750,000. These changes only affect people who live in states with high property values and taxes. Except for the Chicago area, most of these states are in the northeast and the west coast.
The tax plan doubles the standard deduction. For singles, it goes to $12,000 and for married and joint filers, it goes to $24,000. This means that an increase in your income of $6,000 for individuals and $12,000 for joint filers will not result in any additional taxes. In addition, the tax rate on your taxable income will be lower. The point is that most of the middle class will pay less in taxes.
The notion that only rich people will get reduced taxes is pure nonsense. The tax rate has been reduced for all brackets. This means paychecks for everyone who gets paid for working will be larger since the government is taking less. This will become abundantly clear when people receive their new paychecks showing lower deductions for taxes and more take home pay.
The criticism of the plan is based on two things. First, the deduction limitations affect people who live in states with high property values and high state and local taxes.
Second, there is criticism that poor people won’t get a tax cut. In a sense this is true. People who don’t pay taxes won’t get a tax cut.
As my daughter commented when we discussed this, “How can people who don’t pay taxes get a tax cut?” Obviously, they can’t. But this kind of rhetoric appeals to people who distort the truth for their personal gain. It plays well in the press to stand up for poor people who don’t work.
In summary, we are not entering a recession. The correction in the market may last a few weeks or it may end as early as Monday afternoon. But I expect the market to resume its rise within a month or two. And, contrary to criticism, the tax reform legislation passed in December is good for businesses and good for the USA.