CORPORATE TAX REFORM, SEASONALITY AND INFLECTION POINTS
Yesterday (Thursday, August 17), the S&P 500 declined -1.54%. Accompanying the decline was a slight increase in volatility-related measures (indicating some fear, but not a lot), a slight increase in hedging activity, and a huge increase in the level of hysteria on CNBC (no surprise there—ratings are important). Overall, however, given the current and typical low volume summer seasonality, the markets behaved in an orderly manner.
The impetus for the decline was attributed to a rumor that Gary Cohn, the chief economic advisor to President Trump, was going to resign. Investors view Mr. Cohn as the driving force behind the administration's push for tax reform, especially for businesses. Should he depart, they reason, corporate tax cuts may take longer to enact, could be watered down, or may not even happen.
Earlier this year, Ned Davis Research published a study indicating that "a reduction in the corporate tax rate to 20% would boost EPS by at least 7%. A combination of lower taxes, higher oil, and better economic growth could push the number to 18%."
Leaving aside the prospects for higher oil prices and a jump in economic output, let's consider the idea that lower corporate tax rates could increase earnings while keeping an eye on valuations and expected earnings gains for this year.
Currently, 2017 earnings estimates for the S&P 500 are $127.14 (down from $130.92 at the beginning of the year). There are two ways to look at the earnings forecast: 1) that the forecast doesn't include the potential increase in earnings from corporate tax reform (lower corporate tax rates), or 2) the forecast does include some of the expected improvement from tax reform.
There isn't a clear answer. However, we can make anecdotal inferences. For example, given that equity market valuations are expensive, we can infer that investors may be willing to pay higher prices for stocks with the hope that corporate tax rates will be reduced and earnings can catch up to prices (among many other factors).
We've also noted that a small number of analysts were starting to adjust their earnings estimates higher to reflect the possibility of lower tax rates, an idea that was not yet widespread but gaining speed.
Lastly, of course, was the action of the market itself. The decline seemed to occur as investors repriced the possibility, timing and potential magnitude of tax reform. This tells me that there are at least some tax-related earnings expectations in the current earnings forecasts.
If the earnings contribution for the S&P 500 from a tax reform package did indeed impact earnings by 7%, the math is pretty simple. Seven percent of the current earnings estimate of $127.14 is about $8.90 of earnings. If you multiply the $8.90 of earnings by the year-end 2017 P/E multiple of 19.2x, then tax reform could be reasonably expected to impact the S&P 500 by 170 S&P 500 points. Yesterday, the S&P 500 was down 38 points.
We don't know if tax reform will happen (we suspect it will), much less the specifics of rates, deductions, expensing, and more. We do believe that investors are pricing in the possibility. And perhaps most importantly, the high-valuation (expensive) environment places the markets in a more precarious position if the final tax package does indeed underwhelm.
The markets reacted yesterday to more than a rumor. However, we thought it interesting that it was a dominant narrative and seemed to have some impact.
With regard to the Day Hagan Logix Tactical Dividend strategy, we also thought it would be a worthwhile exercise to review the effective tax rates for our current portfolio holdings. Below is a table illustrating the companies we hold with the highest effective tax rates. These would likely benefit most from clean corporate tax reform legislation. Keep in mind though, whether tax reform occurs, and regardless of the form, we continue to view our holdings as representing significant value and opportunity.
Before I leave the subjects of earnings, valuations, and expectations, I thought the following quote from Howard Marks, resident sage at Oaktree Capital, to be quite sobering. He writes, "While the 'p' (price) in p/e ratios is high today, the 'e' (earnings) has probably been inflated by cost cutting, stock buybacks, and merger and acquisition activity. Thus today's reported valuations, while high, may actually be understated relative to underlying profits." In other words, earnings have been manipulated higher by financial engineering. Without the financial engineering, high valuations might even be higher.
While tax reform has recently captured the admittedly short attention span of investors, for the time being, there are potentially several inflection points coming up over the next few months. These inflection points are arriving during a time that has historically evidenced cyclical weakness. To illustrate this point, the next chart is a cycle composite constructed by Ned Davis Research, using a combination of the 1-year seasonal cycle, the 4-year Presidential cycle, and the 10-year decennial cycle. As you can see, it portends a period of cyclical weakness over the coming months.
As we enter the period, we'll be monitoring the following events:
- U.S. and South Korean military exercises start August 21
- The U.S. and South Korea begin trade negotiations on August 22 (we thought the timing was interesting too)
- Jackson Hole Economic Policy Symposium begins on August 24 (Yellen speaks on the 25th)
- Next round of Brexit talks begin on August 28
- Congress returns on September 5
- Trump expected to provide tax blueprint on September 5
- ECB meets on September 7
- Fed meeting decision on September 20
- German elections on September 24
- AAPL i8 launch in September
- U.S. debt ceiling likely to be hit around late September to mid-October
- U.S. spending authorization expires on September 30
- October – third quarter earnings' season begins
Although seasonality is a secondary consideration for us from a research and weight-of-the-evidence perspective, the cited litany of events does seem to be lining up in an interesting way.
Bottom Line: Our models and indicators continue to portray a message of cautious optimism. While we can find plenty to be bearish about, we also see rays of light when perusing recent economic data, employment, consumer, and business confidence. At this juncture, our overall positioning is neither overly bullish or overly bearish. We continue to be risk-averse and seek rational returns while managing the potentially substantial influences surrounding the markets.
Late addition: In yesterday's quarterly Day Hagan Logix Tactical Dividend webinar, we discussed our positive outlook for our energy holdings. This morning, Art Huprich, our Chief Market Technician, forwarded me this blurb from the Raymond James energy team:
"Some names in the space are at or below the early 2016 lows despite the price of oil being about $20 higher, and very few companies have been spared the carnage. Out of the 31 Energy companies in the S&P 500, only three closed yesterday above their 50-day moving average; 15 hit new 52-week lows. Sentiment in the group is so negative that just a hint of positive news could drive a significant rally." We agree wholeheartedly.
Have a wonderful week,
Donald L. Hagan, CFA
— Written 8-18-2017
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