Crossing Wall Street Review – January 12, 2018
By Eddy Elfenbein, editor of Crossing Wall Street and portfolio manager of the AdvisorShares Focused Equity ETF (Ticker: CWS)
The Impact of Tax Reform on Our Portfolios
As we know, the stock market has been in a good mood lately. Actually, it’s been this way for close to two years without interruption. On February 11, 2016, the S&P 500 closed at 1,829.08. Since then, the index has advanced 51.3%. Not only that, it’s been a very stable market as well. Since March 2016, the S&P 500 has spent exactly one day below its 200-day moving average.
Part of the reason for the buoyant outlook is tax reform. Last month, Congress passed and President Trump signed a major tax bill. I won’t go into the wisdom of the policy proposals, because that’s a political decision and not what we focus on around here.
I do, however, want to make a few comments about the change in corporate taxes and how it impacts investors. The tax law lowers the corporate rate from 35% to 21%. Effectively, what that means is that the U.S. government is a silent partner in every American business.
Previously, they had an odd relationship with the partners, because the government owned no part of the business, yet they were entitled to 35% of the final cash flow. All the other shareholders got the other 65%.
With this new law, the shareholders’ stake rises from 65% to 79%. They get an extra 14% at no cost. Imagine if you had a silent partner who said to you, “here, take my 14% and you don’t owe me anything.” Of course, that’s not literally what’s happened. But effectively, it’s pretty darn close.
This is a huge benefit for shareholders. It’s almost like, overnight, you got 20% more shares of all your stocks. This is especially good for profitable stocks because they pay a lot of taxes.
I tend to be skeptical of any models that try to determine a fair price for the entire market. This is an instance where the entire climate has changed. If I were a modeler, I’d have to update several of my variables (and not a few of my constants).
As good as this is for shareholders, and it is good, we should keep in mind that the government may easily change its mind at some point. The political climate, alas, is ever fickle.
Keep an Eye on Rising Long-Term Yields
Last Friday, the government reported that the U.S. economy created 148,000 net new jobs in December. That was less than expected, but the trend is still very much intact. The unemployment rate stayed at 4.1%. The important number is that average hourly earnings were up 2.5% for the year. That really needs to increase. Higher wages means more shopping means more profits.
While inflation has remained quite low, I’ve started to notice that long-term interest rates have gradually crept higher in recent weeks. This week, the 10-year broke above 2.5%. One more push, and the yield can easily touch a three-year high.
Some of this is due to the improving economy. As cyclical stocks improve, that’s usually matched by a rise in long-term rates. What happens is that investors shun lower-risk bonds and rotate into higher-risk stocks. That’s also part of the reason why defensive sectors like consumer staples (like Hormel and Church & Dwight) have sat out this latest rally. We’ll get the first look at Q4 later this month and I think it will be a good report. We might even top 4% growth.
Some of the rise in long-term rates is related to the Fed’s aggressive posture. The central bank sees three more rate hikes this year. The futures market has priced in a rate hike in March (68%) and a second by September (71%), but they’re currently divided on a third (45%) by December.
The reason why the rise in long-term rates is important is that it’s a crucial factor in stock valuations. Whenever someone asks, “are stocks expensive?” the proper answer is “compared to what?”
In terms of risk, stocks are closest to long-term bonds. That means that higher yields from bonds provide tougher “competition” for stocks. (This is why so many market models use long-term yields as an input variable.) If stocks want to compete for investors’ money, they may have to lower their valuation. This doesn’t necessarily mean lower prices. It just means that prices will rise less than earnings.
Mind you, we haven’t reached a breaking point yet. Long-term yields are still quite modest. But there is some math involved, and stock valuations can’t hold out forever—even with tax reform.
The key takeaway is that the market is taking a more relaxed attitude toward risk. This isn’t necessarily a bad thing. Marginal assets serve an important purpose.
When the 10-year yield was 1.4%, as it was 18 months ago, stocks were an easy call. Heck, even if they went nowhere, you were still getting a 2.2% yield. But what happens if the 10-year gets to 3%? Or 4%?
In 1994, the bond market tanked, profits soared, and stocks were flat. That’s another way of saying valuations plunged. Sometimes the bear growls, and sometimes he does his work in silence.