The tax bill is almost done, so the debate is whether to sell on the news.
It may be happening already. Stocks retreated on Tuesday, and even a notable rise in 10-year Treasury yields failed to move bank stocks up. (Stock prices were mixed on Wednesday.)
There's reason to consider that this month's notable rally should at the very least pause.
Bears argue:
1) The market is overbought on a short-term basis.
That's certainly true. The is up more than 3 percent in the last few weeks on hopes a tax cut will boost corporate profits in 2018, and banks, a sector that would greatly benefit from tax cuts, are up almost 7 percent.
Markets since Nov. 27:
- S&P 500: up 3.2 percent
- Transports: up 9.5 percent
- Banks: up 6.6 percent
- Russell 2000: up 2 percent
- Semis: down 4.9 percent
- Tech: flat
Notice that technology, and particularly semiconductors, a sector that would see fewer benefits from tax cuts, has underperformed. So, to some extent, there is already a "sell on the news" mentality.
2) Stocks are expensive, even considering the tax cuts.
Also true. Most analysts believe S&P 500 earnings for 2018 will increase anywhere from 8 percent to 11 percent, without tax cuts. Tax cuts, depending on whom you talk to, could add 5 percent to 7 percent to that.
This puts stocks in a very expensive range: anywhere from 18.5 times to 19 times 2018 earnings without tax cuts. Throw in tax cuts, and you still have multiples of 17.5 or higher.
That's closer to the historic average. Here's the problem: To really move the S&P forward on these numbers, you have to argue that the multiple should stay higher, say, close to 20. Put the multiple at 20, and with tax cuts, you can easily argue that the S&P 500 should hit 3,000 in 2018, up (an attainable) 11 percent.
That's exactly what bulls are arguing. The market deserves a high multiple.
Bulls say:
1) The global economic expansion, coupled with low rates, will continue to justify a higher multiple.
Dubravko Lakos, head of U.S. equity strategy for J.P. Morgan, when asked on CNBC if markets would be selling on the news into January, said Tuesday: "I think there are still too many positive catalysts to see a big pullback right now. I think you could get a bigger pullback as you get into Q2, Q3 of next year — I think Q1 is relatively well supported. And I do think that January we could get a pretty outsized rotation still in the market."
2) The yield curve has begun to steepen again.
For months, the spread between the 2-year and 10-year Treasurys has been declining, going from roughly 80 basis points in October to a low of about 52 basis points on Monday. But in the past two days, it has been rising to about 61 basis points. Bulls argue that this is a sign bond traders think tax cuts could help kick up economic growth. Maybe, but bank stocks have not moved on the news.
It's hard not to argue for some kind of market pause going into the close of the year. James Paulsen, chief investment strategist at Leuthold Group, is one of many who say the market may already have priced in the tax cuts. Wharton professor Jeremy Siegel agrees. "All the good things about the corporate tax plan have been built in over the last two months," he said on CNBC on Tuesday.
But there's a third alternative, a middle ground between "the rally keeps going" and "sell on the news." Lakos brought this up: whether the market can successfully continue the rotation it has been seeing in the past month into the beginning of the year.
That rotation, into stocks that would benefit from tax reform (banks and oil stocks, especially) and out of those that would benefit the least (especially technology), has been quite notable. Vanguard Value ETF (VTV), a basket of stocks that would mostly benefit from tax cuts (banks and oil stocks), is up 4.5 percent since the end of November, notably outperforming the tech-heavy Vanguard Growth (VUG), up only 1.8 percent.
My bet? The key is the global growth/low rates story. If that paradigm remains the dominant story as we go into the first quarter, then growth stocks are likely to still dominate the new high list.