What Happened After the 1986 Tax Reform?

One way to get a handle on the likely course of the markets next year is to see what happened after the 1986 tax reform legislation, the previous effort to reform the tax code before this year's.  This past episode suggests stocks have more room to climb over the next few months while Treasury yields risk jumping above 3% this Spring.   Such a scenario would fit with the one I outlined in my October 29 blog.  But, the 1986-87 market behavior suggests there could be abrupt shifts in the market, which will probably be difficult to predict.

The earlier tax reform legislation passed in October 1986.  It may have helped to boost economic growth from an already strong pace.  Real GDP Growth sped up to 4.5% in 1987 from 3.0% in 1986.  Inflation also sped up, with the Core CPI rising to 4.2% in 1987 from 3.8% in 1986.

In 1986-87, the S&P 500 Index rallied by 14.2% over the 4 months following the tax reform law (see table below).  However, the rally had followed a wobbly market over the prior 4 months, in which there was a 2.8% pt cumulative decline.  Some of the post-law rally may have been catch-up.
The current situation has a different start.  Stocks rallied a cumulative 5.5% over the 4 months prior to the 2017 legislation.  So, there should be less of a catch-up now than in 1986-87.  Nevertheless, net of the market behavior prior to the tax law, stocks still have room to climb another 10% through April if they are to be consistent with the post-1986 experience.  To be sure, such a gain is unlikely now, given the very high price-earnings ratio for the S&P 500.  The P/E Ratio was high relative to the prior few years in 1986-87, as well, but not as high as now.

In the earlier episode, the 10-year Treasury yield fell 37 BPs after the legislation was signed, having backed up 28 BPs in anticipation of the bill.  The decline in yield proved temporary, however, with a massive sell-off in the 4th month after the legislation went into effect.

Currently, Treasuries sold off only at the end of the month when it was certain that the legislation would pass.  This sell-off also could unwind before resuming, as in 1986-87.  But, the unwinding would likely be smaller than in 1986-87, inasmuch as the prior backup in yield was smaller to begin with.

The run-up in yields, along with a market focus on the Trade Deficit and weaker dollar, eventually resulted in the stock market crash of October 1987.  This history suggests that significant downside risk to the stock market could develop in the second half of 2018.  Moreover, rather than a wider Federal Deficit being the big problem facing the markets, a wider Trade Deficit (and consequently  a weaker dollar) could be the main perceived problem as the tax-related boost to spending results in a surge in imports.
 
      Month                      S&P 500                     10-Year Treasury Yield
                                  (m/m % change)          (level, percent, monthly avg) 
                                  1986-87       2017                   1986-87       2017
       t-3                       -2.1             -0.1                     7.30              2.35
       t-2                        2.0              1.9                      7.17              2.36
       t-1                       -2.7              2.3                     7.45               2.20
       t                           0.0              1.4                      7.43               2.39
       t+1                       3.2                                        7.25
       t+2                       1.4                                        7.11
       t+3                       6.4                                        7.08
       t+4                       6.2                                        8.02
       t+5                      -0.8                                        8.61
       t+6                       0.7                                        8.40    
     
t = month tax legislation was passed