Tax Stimulus and Global Synchronization

The previous post briefly touched on market expectations for tax cuts and how various interests are competing to get certain provisions passed. Now that both houses of Congress have passed their own version of the bill, they will hash out the gory details and pass a final version. How this will affect individuals will differ based on your income, wealth, and location – a subject difficult to address broadly. The question we will focus on is how will this affect our aging bull market. The bill is overwhelmingly a gift to those with capital and to corporations more generally and stocks will surely get a lift from the corporate tax cuts. When companies pay less in taxes it frees up cash for mergers and acquisitions, company stock buy-backs, and distribution of dividends. Credit Suisse estimates that the 20% proposed corporate tax rate will boost earnings by 10% in 2018. The tax cut is coming at a very late stage of this bull market and has some investors worried that it will ignite inflation. One would think this would be cause for serious concern, but these are not normal times. Remember, we are just 8 years removed from the biggest economic catastrophe in a century. Inflation in the US on a year-over-year basis is currently running at 1.6%, which is not high. And although interest rates are low (conditions that are typically inflationary) the Fed has made it clear they will do everything they can to not allow a hyper-inflationary environment to develop. When you combine low inflation, increased corporate cash, and steady US growth with increased global growth, stocks look attractive even at these elevated valuations.

World manufacturing activity is at nearly 7-year highs as orders are coming in faster than anticipated and exports and employment are all up. By many indicators, global economic health has never been more robust. The number of countries in recession has dropped to its lowest level in decades. Synchronized global growth is finally in sight with no major industrial economy in contraction mode for the first time since 2008. World GDP is expected to advance to 3.5% this year and jump to 3.7% in 2018. For the stock market, this is all good news. More specifically, companies with exposure abroad have tended to reap the benefits over the last year. Those that derived 50% or more of their sales overseas reported revenue growth of 10% compared to 5.8% for all S&P 500 companies regardless of where revenues came from. In short, stocks have been on a long ride up but there are good reasons to believe the journey is not yet over.

Death and Taxes

As the Senate nears its vote on taxes, the minutia of the bill will be debated on the Hill with the hopes that some parts of it die before making it to final vote. One such provision is a change to capital gains taxations. Currently, investors can choose which “lots” of stock to take from when they sell. For example, a long time Apple investor may have bought the stock many times over the years with the oldest lots having a cost basis of a few dollars. If they were forced to sell the oldest lots first, an accounting method called First In First Out (FIFO), their capital gains would be enormous. However, if they sell the most recent long-term gains (as they can presently) the story would be much different. This is just one of the myriad changes proposed in the bill.

The US tax code is one of the most complex in the industrialized world and the effects of any changes are incredibly difficult to predict. But what we know for certain is that in the short-term the markets will be thrilled with the changes overall. On a longer time-frame economic implication are less certain, except of course for the massive deficits, which apparently both parties in the US love these days.

Fed Focus

The Fed kept interest rates unchanged for the month as was widely expected. However, the anticipation by investors of a rate hike coming next month is nearly unanimous. The Fed has been telling us for some time that the robust corporate earnings and job growth are warrant interest rate normalization - and they have a point. The unemployment rate is 4.2%, and this earnings season has seen three out of four companies surpassing earnings expectations and beating sales estimates, driving market prices to all time highs. As the Fed acts, we will be focusing on one of the oldest investing mantras on Wall Street - "don't fight the Fed". Higher interest rates might spook some investors and send them to the sidelines while the new rising interest rate era gets under way. Nevertheless, we don't scare easily and will remain focused on growing and maintaining wealth.

Earnings Trump Politics

Despite the geopolitical noise, the stock market is at record levels fueled by strong corporate earnings and policy hopes related to tax reform. Overseas we are seeing sustained, above-trend economic output and steady earnings growth. Risks to foreign investments include the ever-present geopolitical factors, as well as changes in currency values as the dollar could strengthen on rising US interest rates and FED actions.

The optimism in the market is something we haven’t really seen in eight-plus years. Markets are the most stable and sustainable when there is a healthy amount of fear and skepticism. Right now, it seems like investors have grown a little too complacent. The economic fundamentals are still strong and warrant a growing market but it may be too much too fast. We expect some sort of a pullback in the coming weeks or months followed by continued economic growth and market expansion.

Winter is Coming

Winter is indeed coming but the markets are still partying like it's spring break. From a contrarian point of view this is a troubling sign. US household equity exposure is approaching all time highs. We are due for a normal draw down of some kind in stock prices, however because of the high level of investment this could push for a mass move to the exits. As long as the economy keeps growing though, these pullbacks will be opportunities for purchasing beaten down sectors. We remain vigilant. Winter is coming, but it's not yet here.

Dog Days of August

We are right in the midst of a seasonally weak period - end of summer, beginning of autumn. From a technical point of view, the S&P is looking for direction. The market is in a secular (long-term) uptrend and a short-term downtrend. Fundamentally, stocks are very highly valued relative to their history. This valuation is based on a number of factors: extremely low interest rates, huge amounts of liquidity from central bankers, global economic expansion, and favorable regulatory environments. This entire bull market dating back to 2009 has been marked by naysayers and reasons to stay on the sideline. In general, this is a very good sign for investors willing to take the risk. When investor sentiment teeters towards overconfidence and euphoria is when it's time to start taking profits. At some point a bear market will come, but as long as we continue to hear about it from every corner of the investment community I doubt it will come now. Nevertheless, we are very vigilant of events that could spur a violent market reaction. Namely, a rapid uptick in inflation or major shake-up in Washington.

Running with the Bulls

The market continues to act as if in cruise control. The drivers of this ride have been US and global economic growth (both underwhelming but steady), earnings per share growth, US regulatory action, and Federal Reserve policy. Low inflation and continued economic output are making for the perfect scenario for stocks. The Fed is staying cautious so as not to stifle the economy and major companies like Apple, Amazon, and Netflix have money coming out of their ears. Stay tuned for more to come.

From 3/1/17

Stocks are melting up. The S&P is up over 11% since early November representing tremendous optimism by traders. The stock market acts as a forward-looking predictor of corporate earnings. And since Trump has been in office he has vowed to make changes that should greatly augment earnings. These mainly have to do with “massive” tax cuts for both individuals and companies, and the removal of regulations and protections in order to maximize profits. Alongside future expectations, the current economy is chugging right along.

On Valentine’s Day, Federal Reserve Chair Janet Yellen held her monthly testimony on Capitol Hill – or more accurately her sit down and get yelled at and blamed for all things financial by grandstanding politicians. She was asked if the market seemed overly optimistic of late and her answer though guarded, pointed out why traders might feel that way. The GDP in the US grew by 1.9% in 2016, same as 2015. Inflation is still relatively very low around 2%. The labor market has improved dramatically in the last 9 years as the unemployment rate stands at 4.8%. Additionally, the Fed will continue to buy US Treasury Bonds supporting the bond market and keeping interest rates relatively low for the foreseeable future.

A market pull back could come at any time and indeed will. It is not uncommon to see short-term sell-offs of 3-5%. Nonetheless, market fundamentals remain strong and the overall strength of the uptrend is telling us economies are on the right path. We remain vigilant and are always on the lookout for any indication that a downtrend or recession is ahead. But as of now both economic fundamentals and asset price trends show we are a while away from any real danger. Something to look out for is how the markets react to rising interest rates. The Fed chairwoman made it clear she would raise rates in an orderly fashion, but how the market responds will be constantly evolving. One thing we know for sure is that every move this presidential administration intends to make is inflationary (lower taxes, increased spending on infrastructure, tariffs on imports, etc.). This could cause the Fed to raise interest rates at a faster clip than they would like and would almost certainly cause a sell-off in stocks and hamper growth. The market is anticipating steady economic expansion and traders seem to believe Trump’s fiscal initiatives will move forward but be tempered (by congress or whomever) and there will not be an explosion in deficits or spending or inflation. This will all be something to keep an eye on.

8/4/17

The market marches on.