Strategist's Corner

Divergences Dent a Spectacular Year

James T. Swanson

Chief Investment Strategist

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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 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% on a total return basis versus around 22% for the index as a whole (as of 20 December), 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% and the index as a whole by more than 25%. 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 price of crude oil. In past instances, this has 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 recently-passed US tax bill. The bill 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% over the previous year, all else equal. However, the high-flying tech sector, with their heavy overseas sales, pay an effective tax rate, on average, of about 19-20%, close to the new statutory rate of 21%, so they likely won’t be helped as much as some optimists are predicting. Under the new tax bill, highly-indebted companies could end up worse off, as they will not be able to deduct interest expense above 30% of their cash flow. Companies with large research and development budgets, such as pharmaceutical companies, and big capital goods manufacturers will likely benefit from the immediate expensing of short-lived capital investments. Overall, the bill is generally beneficial for large-cap US companies, but not in equal measure. Your mileage may vary.

It’s my view that the passage of the tax bill won’t lift all stocks immediately or in lasting fashion. I would not use the approval of the package as justification to blindly purchase baskets of stocks. There are devils in the details 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.

 

The views expressed are those of James Swansonand are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase
any security or as a solicitation or investment advice from the Advisor.

Unless otherwise indicated, logos and product and service names are trademarks of MFS® and its affi liates and may be registered in certain countries. 

This content is directed at investment professionals only.

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