Year End 2017

New Tax Law and Corporations

The big event of the fourth quarter of 2017 is that Congress devised a new tax bill and passed it. The stock market had a surge in the fourth quarter in anticipation of a greatly reduced tax bill for corporations. Corporate taxes ranged from 15% to 35% under the previous law, but with the passage of the new law, they will drop to a flat rate of 21%.  The alternative minimum tax was repealed for corporations, which will be a big win for some. Expensing of depreciable property was raised from $520,000 to $1 million, indexed for inflation and expanding the types of property included. Finally, there is a temporary 100% expensing for certain “qualified property”; that is, property with a recovery period of 20 years or less (such as computer software), which will help future earnings. Overall, corporations did very well with this tax change. The one big loss is the deduction for interest on loans, such as bonds. This may mean that corporations will issue more stock rather than bonds. Also, the deduction for many fringe benefits has been lost (such as entertainment, reimbursement for parking, etc.)

All of this should translate into greater net profit to corporations. With a reduction of 14% in taxes for large corporations, they should be in a good position to invest more money into the business, pay higher dividends and increase wages. All the above is expansive in nature. The stock market, recognizing the value of the tax benefits bestowed on corporations, became very bullish and delivered its best performance in many years.

New Tax Law and Individuals

The bill makes some fundamental changes to the tax code for individuals. The most significant was to eliminate the personal exemption and to increase the standard deduction for individuals to $12,000 and to $24,000 for married filing jointly. This is expected to reduce, by about 60%, the number of individuals who itemize their returns. A cap was also placed on the amount, if you itemized, that you could use for municipal and state taxes. This limit is now $10,000 regardless of whether you file as an individual or jointly.  This limitation may further reduce the number of people who will itemize.

Tax brackets were also changed with the elimination of the 15%, 25%, 28%, and 33% tax rates being replaced by 12%, 22%, 24%, and 32%. While the tax rates dropped, the amount under each was expanded. For example, the prior 25% bracket went from $77,401 to $156,150 while the new 22% bracket starts at the same place but goes to $165,000. The child tax credit was raised from $1,000 to $2,000. The brackets for capital gains have been increased as well. Under the old law, for example, you paid 0% up to $36,600 of earnings; now that has been raised to $77,200, meaning far more people will pay nothing on capital gains.

Many additional changes are specific to certain issues. One that does impact us is that money in a 529 plan can now be used to fund elementary and secondary education in addition to higher education and vocational programs. 

Market Review

For the year, the S&P 500 index was up 19.4%. Some of you may remember 1995 when it was up 37.6%. This was a remarkable performance and certainly not one that was anticipated at the beginning of the year. Consumer spending was strong, earnings have been increasing and jobs are plentiful. Business spending is up, profits are up, and taxes are headed down in a very meaningful way.

Let’s look at the numbers: at the beginning of the fourth quarter, the S&P stood at 2519 and ended at 2674 for a gain of 6.2% for the quarter. The year began with the index at 2239, and with the closing at 2674 there was a gain of 19.4%. 

The S&P MidCap 400 was up 6.3% for the fourth quarter. The full year gain was 14.5%. The S&P SmallCap 600 was up 3.8% for the quarter and 11.7% for the year. Reducing the corporate tax does not appear to be as beneficial for these smaller companies, and may even result in higher taxes for them.  The international markets, represented by the DJ Global ex U.S. Index, were up 5.9% for the quarter and 24.7% for the year. The 10-year Treasury Note rose from 2.33% at the beginning of the quarter to close at 2.41% at year-end.  This close was just .03% lower than the close on December 31, 2016, which was 2.44%. The Bloomberg Barclays US Aggregate Bond Index, which uses investment grade government bonds, corporate bonds and mortgage-rated bonds with at least one year until final maturity, had a yield of 2.97% at year end. We will follow this index in the future.

What do all these numbers Mean?

To have a diversified portfolio, you include a variety of asset classes. In a broad sense, U.S. Equities is one asset class. These

equities, whether they are large, medium or small, are highly correlated, meaning that if one group is going up or down the others in the group are probably doing the same thing. A non-correlated group of assets to U.S. Equities would be U.S. Bonds. These can include U.S. Treasury bonds, corporate bonds and mortgage back bonds. These assets do not move in step with U.S. Equities but they, as a group, are correlated. This notion of correlation is very important in attempting to reduce risk in a portfolio.

Sometimes the negative part of diversification and non-correlated assets is that a particular asset class does very well in a given year and you think “look at how much I could have made if I had just put all of my money in that asset class”.  Of course, you don’t know at any point of time which asset class will do the best or the worst. That is the reason for diversifying.  

Conclusion

As I look at the fundamentals of both the U.S. and world economies, things are looking bright. U.S. and world businesses appear to be growing, increasing earnings and developing good workers. In the United States, we basically have full employment. Individual workers can worry less about being laid off and have a sense that they can change jobs. Workers are earning more money. All the above makes the consumer feel better about where they stand financially and makes them more willing to spend. This is a good situation for increasing stock prices. With this growth we are likely to see bond interest rates as well as corporate dividends rise.

Ed Mallon

Disclaimer: Secure Planning does not provide tax advice, clients should consult with their tax professional regarding their specific circumstances.

Posted January 19, 2018