What does the Tax Cut mean for the Stock Market?

What does the tax cut mean for the Stock market?

Many people are wondering what the tax cut means for the US Stock market. We thought it might be helpful to take a good look at some historical patterns and overlay a bit of common sense on what tax cuts might mean for the future. With that said, let me quote famous investor Warren Buffet in saying, “If past history was all that is needed to play the game of money, the richest people would be librarians.”

Key Starting Points

• Some portion of tax cuts will be passed along to investors.
• History generally shows that companies don’t see as big a benefit from tax cuts as many may think, on aggregate.
• Market valuations relative to interest rates is likely a stronger driver for 2018 returns, but may be overshadowed by tax talk
• Removing uncertainty is the real win for markets

Part of the gains in 2017 was a direct link to the “possible” tax cuts coming. Many firms built in some level of tax cuts into 2018 earning projections. This optimism for increased earnings certainly helped add to the market rally in 2017. How much more is yet to be adjusted for company projections is yet to be seen. We have generally found analyst project another 25-50% of companies needing to adjust forward earnings for potential benefits. But little is known about the level of benefit. Lower corporate tax rates certainly will not hurt companies in 2018, and will allow some added money flow. Higher dividends, stock buybacks, bonuses, increased salaries, debt pay down, buyouts, expansion, among other items are ways a company may deploy the benefit. Some of these have greater employee, market and economic benefit than others, and we simply do not know the aggregate effect.

History shows the actual tax benefits are usually not as large as many may think. For example; after accounting for tax breaks and structural work around, U.S. corporate rates are well below the 35 percent top statutory rate and are currently in line with corporate rates in similar countries. (The Treasury Office of Tax Analysis)

The average corporate tax rate on profits from new investments made in the U.S. is 24 percent; the average corporate rate on profits from new investments made by companies in other “Group of Seven” (G-7) industrialized, democratic countries, weighted by the size of their economies, is 21 percent. *

Cutting the corporate rate from 35% to 20% will certainly help some companies, but many larger companies currently pay around 24% using the current breaks and allowable structures. The new code will simplify this element, but the break may not be as earth shattering as it first appears.

Since 1927, we’ve cut corporate taxes 10 times. The following year, U.S. stocks have risen six times, 60% of instances, averaging 11.3% increases per year. We’ve also hiked those taxes 13 times. Stocks rose the next year nine times, 69% of instances, averaging 12.5% annually. Cuts? Hikes? About the same frequency and size of gains, regardless. *

The bigger driver of stock returns long term tends to be valuations relative to interest rates.** Visualize buying a home for a moment. With interest rates at 15%, the amount of home you can afford is much less than today. Why? Because your monthly payments are much higher. If your mortgage rate dropped to 2%, you can afford a much larger home. The same dynamic holds true with valuation of a market made up of companies, which are comprised of assets that drive earnings. Companies can return much more cash to shareholders with rates lower. If they get too high the company will need to pay down debt, expand slower, and return less to shareholders. In addition, institutions will start valuing stocks less when compared to lower risk bonds as rates increase, placing more pressure for a correction. The current market expectation of 6-8% annualized returns over the next 5 years may seem low relative to possible temporary declines of 20,30,40%.

However, when compared to a 2.4% yield on a 10 year Treasury, a 7% return possibility still looks really good (reference methodology disclosure). Until we experience a major fear event or higher interest rates; stocks will continue to look like the best game in town….albeit at a much higher risk than 8 years ago. With Jerome Powell as new Fed chairman and pressure to leave rates very low while reducing bank regulations, we may have an environment for continued market appreciation. Corporate tax reform will not hurt, but the real driver is likely a relationship between interest rates and stocks. Do you want a bond at 2.4% or a stock with a 7%+ potential? Until fear happens, most are still choosing stocks. As for us, we are preaching slow and steady with a good balance to meet objectives. It is possible that a short term gap in tax revenue receipts relative to expenditures could create need for government to sell more treasuries which would increase rates faster and hurt the market. This possibility, coupled with lower bond purchases from Europe may start to pressure markets a bit more regardless of the tax benefits. Warren Buffett once said that as an investor it is wise to be “Fearful when others are greedy and greedy when others are fearful.” Seems like we are wise to keep some balance on the current market greed.

Conclusion

The ultimate win from tax reform has been the removal of uncertainty. Similar to the election, we have less uncertainty today than we did before. Inevitably, some companies and people will win and some will lose from the change. The certainty now provided allows us as managers to accurately evaluate each investment with a deeper understanding of the future tax structure. We know companies whom compete solely on price will have increased competition with lower taxes, as new competitors might now be able to underbid them. Companies whom hold stronger brand qualities, and service levels will likely be able to capitalize on retaining more benefit from the cut. Clarity around tax structure will now produce clarity around analysis, which is always good.

History shows the markets win after a tax cut OR tax hike more often than not simply due to added clarity. We are bullish on the clarity but we understand each event and time is unique. Interest rate fluctuations will loom large in moving the long-term market dial, and we must keep a close eye. The future will not be the same as the past and we must remain disciplined to not exercise poor judgment of extreme optimism or pessimism but rather choose a balanced path, rooted in data and fundamentals with each decision we make to best achieve your objectives.

*(The Treasury Office of Tax Analysis, USA Today, Ken Fisher)

**Vanguard Research, Forecasting Stock Returns by Joseph Davis, Ph.D., Roger Aliaga-Díaz, Ph.D., Charles J. Thomas, CFA

***Methodology for projected 6-8% nominal equity return.

Method 1: Vanguard Research, Forecasting Stock Returns by Joseph Davis, Ph.D., Roger Aliaga-Díaz, Ph.D., Charles J. Thomas, CFA.

Method 2: Dividend +Earnings Growth + Valuation = current S&P 500 dividend of 2% + 5 year Earnings Growth of 3-5% + Valuation of -2 – +2%. = 3% to 9%

Method 3: SPY: Book Value: $798.64, Average ROE: 12.7%, Reinvestment Rate: 40%, Price (SPY): $2,716

Using this information, we can compute growth in equity and earnings at 5% annually ([$798.64*.127*.4]/$798.64) and shareholder payouts (dividends and share repurchases) of $76.20 (.127*.6*$798.64), which gives us a yield of 2.8% on the price of $2,716. US stocks could expect earnings power to increase by around 7.8%/year, owing to 5% growth in book value (and therefore earnings at constant ROE) and a 2.8% yield. Returns over time would equal this gain in earnings power after adjusting for any changes in valuation.

Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance