U.S. Corporate Tax Cuts Boost a Market Dominated by New Era Thinking

the Curmudgeon with Victor Sperandeo


2017- An Incredibly Good Year for Stock Market Bulls:

Barring any last week of 2017 sell-off, the MSCI World stock index is set to record its first ever year of posting a positive total return in EACH and every single month this year.  It has had a remarkable sequence of 14 months of positive returns. 

In the U.S., the S&P 500 is up 22.3% year to date and has gone almost 14 months since the last 3% correction ended on November 4, 2016.  [Credit Suisse noted that Tech and Internet Retail stocks contributed more than 40% of the market's total return in 2017.] 

Currently, the S&P has a Shiller P/E of 32.56, which is twice the historical median of 16.15. 


The Russell 2000 trailing 52-week P/E is 123.89, despite a forward P/E forecast of 18.6 exactly one year ago.


The Russell 2000's current P/E is more than twice what it was at the December 1999 and 2007 market tops (each followed by a ~50% bear market decline). 


-->That implies that if the small cap index of 1989 stocks declined by 50% it would still be HIGHER than it was at previous bubble market tops!


Analysis of U.S. Corporate Tax Cuts:

How can one account for this extraordinary up move in U.S. equities, with seemingly no downside?  Besides the excess liquidity created by global central banks, the promise of corporate tax cuts has played a huge role.  Indeed, the U.S. equity market has been propelled upward each and every day in 2017 there was talk or a bit of progress on tax reform.  Finally, it came to be.  This week, the GOP's hugely unpopular tax bill was passed along party lines, with the corporate rate cut from a (misleading^) headline rate of 35% to 21%. 


^ It's misleading because few U.S. corporations actually pay the 35% top tax rate as noted in the analysis below.


At first look, this would imply a significant boost for U.S. corporate earnings.  However, stock market bulls and cheerleaders forget to note that actual U.S. corporate tax rates have been significantly lower than 35%. 


Top-down numbers, compiled by Society General (SoGen) bank, using actual tax revenue from the BEA national accounts, suggest that the effective U.S. corporate tax rate actually paid is already at 21% on average and much lower than that for large multi-national companies.  That confirmed SoGen's bottom-up calculations using cash tax paid from company reports and account cash flow statements.


Note the SoGen analysis doesn't count the much lower (or zero) tax rates U.S. corporations have on overseas profits (e.g. Apple has $252.3 billion in overseas cash- up from $31 billion in 2010).


SoGen's Arthur Lapthorne:

“So are these tax cuts priced in? We'd argue that every bit of good news looks priced in. Median U.S. stock valuations have rarely been higher on both a forward PE and EV/EBITDA basis and valuation dispersion remains tight in all but a few sectors. To argue for a re-rating seems ambitious. But there has nonetheless been a clear spike in out performance in recent weeks in stocks with higher tax rates. And perhaps this is the real story - one of rotation. But where to? Value is not cheap and suffers from balance sheet risk. Growth stocks are clear losers as they pay relatively little in tax and will have bills to settle...”

New York Times:  In Tax Overhaul, Trump Tries to Defy the Economic Odds, by Patricia Cohen :

Goldman Sachs projected that the GOP tax bill will add just three-tenths of 1 percent of growth in the next two years, before its impact peters out.  The firm’s annual growth estimate of 2.5 percent for 2018 matched the one issued this week by the nation’s central bank, the Federal Reserve, while the latest median Wall Street forecast hovered close by. And in 2019, growth is expected to drop to 1.8 percent, Alec Phillips, chief United States political economist for Goldman, said Wednesday after the Senate vote.


Trey Reik of Sprott: 

We believe the corporate focus of Trump tax cuts is misguided for two reasons. First, lowering corporate tax rates will only exacerbate the economic stratification already plaguing the U.S. economy. As shown in the graph below, corporate profits as a percentage of GDP hover near all-time highs precisely as wages as a percentage of GDP have dwindled toward historic lows.

Corporate Profits Hover Near All-Time Highs (1963-2017)

Source: Meridian Macro; Data from 1963-Q3 2017.

Given how far the economic pendulum has swung in favor of capital-over-labor in recent years, is this really the right time to pursue economic growth through tax cuts on record corporate profits?


Second, there is precious little supporting evidence that reducing corporate tax rates and offering a tax holiday on overseas profits will actually stimulate either incremental capex or increased hiring. One particularly poignant rebuke of the Trump administration’s tax-cut reasoning occurred at a gathering of the Wall Street Journal CEO Council on 11/16/17. With White House Economic Council Director Gary Cohn seated on stage, a WSJ editor asked a room of 100-or-so CEOs for a show of hands, “If the tax reform bill goes through, do you plan to increase your company’s capital investment?” When virtually no hands were raised, Cohn nervously blurted out, “Why aren’t the other hands up?” This awkward scene quickly went viral as a vivid demonstration of how out of sync the Trump tax plan is from common corporate priorities.


During the past eight years, zero interest-rate policy (ZIRP) and related productivity declines have decimated corporate capex in favor of debt-fueled share repurchase. From the equity market lows of Q1 2009 through the first half of 2017, the corporate sector had repurchased 18% of total U.S. equity market capitalization, while institutional investors had liquidated 7% of total equity market cap.  These stock repurchases were funded almost entirely through the issuance of low-coupon debt in a ZIRP world!



A New Era where the old investment rules no longer apply:

Meanwhile, we continue to see market behavior characterized by “new era” thinking:

In our last Curmudgeon post, we reported that Savita Subramanian, Chief .U.S Equity Strategist at BoAML no longer uses the Graham and Dodd value investing textbook, which was her “bible” while studying finance at Columbia University Business School.


There have been many never ending, non-stop bull market remarks we've read from senior market analysts.  For example, “Bull Market Is Continuing With No Sign Of A Major Top In Sight.”


“The stock market (advance) might be slowing down, but there's no stopping in sight” [16 Amazing Stocks to Trade in This Unstoppable Bull Market.]


For good reason, stock market analysts have been mesmerized by this seemingly never-ending bull market grinding higher day after day after day.  It's like an orgy that never ends.

While they may be right for now, we submit the following counter quotes for the reader to ponder and reflect on:  


"The four most dangerous words in investing are: 'this time it's different'" Sir John Templeton


Curmudgeon comment:  But this time (from Feb 16, 2016 to date) the equity market actually appears to be different--at least anything I’ve seen in 55 years of market watching!!!




“How does one reduce the margin of error while recognizing that investments do, of course go down as well as up? The answers are not absolutely clear cut but they certainly include refusing to compromise by subtly changing a question so that it shapes the answer one is looking for” Peter Cundill.

Curmudgeon comment:  Yet from the February 16, 2016 correction low, stocks never have gone down by more than 5% and not even 3% since November 4, 2016.



“High levels of greed sometimes cause new-era thinking to be introduced by market participants to justify buying or holding overvalued securities. Reasons are given as to why this time is different from anything that came before. As the truth is stretched, investor behavior is carried to an extreme. Conservative assumptions are revisited and revised in order to justify even higher prices, and a mania can ensue” Seth Klarman.



"Some grasp of history's abundant lessons becomes especially relevant in the examination of the goings-on in the capital markets where emotions, particularly at extremes, run high - and reason often is overwhelmed.  Careful study of the past would suggest that it's quite appropriate to argue that there are no "new eras" in finance, only "new errors" Frank Martin.



Often investors invent a thesis to justify a trend: "Outsized returns can be realized by purchasing growth stocks regardless of their PE ratios because their PE ratios are not relevant over the longer term." Or "New Economy internet stocks will continue to grow exponentially - and Old Economy stocks are dead and should be sold." In my opinion, booms become particularly dangerous when the theses that justify the booms generally become uncritically accepted by investors. Then, investors are prone to become complacent and to accept the excesses as new norms. History books are full of booms and busts, and booms and busts likely will continue to occur because of the proclivity of humans to become uncritical participants in trends and fads" Ed Wachenheim.


"New eras usually ride into town on the back of a horse mistaken for a golden stallion, transformed momentarily by the brilliance of the afternoon sun.  Incredulous onlookers (investors) are thinking riches, when all that's left when the illusion fades is manure."  Frank Martin.


Victor's Comments:

The major take away conclusion from the last nine years (the so called “New Era”) is this:

Not a single asset price in the world is honest or accurate.

This is due to global Central Bank planning and manipulation, i.e. QE or printing vast amounts of paper currency, negative short-term interest rates, and 5,000-year lows on long bond interest rates (some are still negative!).  That has distorted all other asset prices and effectively means every investible asset in the world is mispriced. That includes: Real estate, Equities, Bonds (from governments to junk), Bitcoin (and other crypto currencies), Art work (especially master paintings), etc. are not what they seem.        

Central Banks not only have set-up the world for an Armageddon like bust, but in the process, they've crushed many financial industries. For example, the hedge fund industry that typically charges 2% management fee +20% (or more) incentive fee is now becoming extinct. How can you justify paying 2+20% for a long/short equity hedge fund when the shorts virtually never go down. (Shorts often cause huge losses when they're covered).  Very few short sellers are fundamental managers who can win in this new game. The only way is picking frauds that go out of business, which is very rare indeed.


The trend following commodity (CTA and managed futures) business has been decimated.  For the last 5 and 10 year rolling periods of “economic recovery/growth” (ending in 2016), real U.S. GDP averaged 2.16% and 1.3%, respectively.  [Note that the 2007-2016 period included the 2008-2009 recession]. 


-->Those are the lowest economic growth numbers in the history of the U.S. from 1789.


Inflation, as measured by the CPI, is highly correlated to commodities.  The CPI had the lowest 5 and 10 year rolling periods since 1961 at1.36% and 1.81%, respectively. If you own a CTA managed account or managed futures fund that uses a trend following program you have experienced a big disappointment in performance, especially if the CTA program doesn't use stock indexes.  

[Curmudgeon comment: Many trend following futures funds have been down by double digits annually the last few years.  I owned several that were liquidated due to severe drawdowns of 50% or more.]


In closing, it appears financial markets are very calm and orderly today and the bull move in U.S. equities will go on indefinitely (“no top in sight,” say the market analysts/pundits). And that's independent of sky high valuations which keep going higher (just check any graph of P/E ratio's). We think the bull move will suddenly END one day without any classical topping action.


The excesses in many markets will all be corrected very quickly when an unknown event (e.g. a Saudi/Iran war?) upsets the ability of the central banks to CONTROL the markets.  At that point in time, every investment market will become massively volatile and buy and hold forever will be a very bad investment strategy.


Curmudgeon’s new email address:  ajwdct@gmail.com


Good luck and till next time...

The Curmudgeon

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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