“Get your facts first, then you can distort them as you please.” — Mark Twain
Recent market activity has once again brought up the potential for a serious correction in equities while stock prices hover near record highs. Of particular interest has been tax reform. Last week a modest selloff in equities (S&P 500 -0.21%, NASDAQ Composite -0.20%) was attributed to heightened concerns about tax reform, which by the way, is not supposedly reflected in equity prices. In our opinion, the only meaningful parts of the legislation will come from the reduction of corporate taxes, including lower rates for small businesses, repatriation of overseas corporate funds, and full depreciation of Capex. Once again the “Wall of Worry” is causing fear, rather than rationality, to dominate the media. The “bearish clowns” reverberate the same rhetoric; overvaluation, Fed policy, political uncertainty, and bearish technical and sentiment indicators signaling unsustainable euphoric momentum. For investors, the political posturing is a distraction, rather than a game changer, although short-term downdrafts in stock prices bring fear of a substantive selloff. Investors sell for no other reason than stocks are up and it’s been a long time since a 10% plus correction. As mentioned numerous times on these pages, a correction (10%+) will eventually occur, but not for the reasons of longevity of a bull market. Bull markets end because the economy is moving to recession and inflation is increasing above tolerable levels (3.5%-4.0%) in a rising interest rate environment.
The Earnings Catalyst
As earnings season moves to conclusion, the S&P 500 has handily beaten consensus estimates. According to FactSet, with 91% of the S&P 500 reporting, “74% have reported positive EPS surprises and 66% have reported positive sales surprises.” (Both earnings and sales are above 5-year averages.) According to Fundamentalis, “removing Energy, which is still lapping easy comparisons from 2016, and the Financial sector with a decline of 7.3% in 3Q2017, S&P 500 earnings grew 8.1%.” Our own proprietary preliminary earnings survey of 700+ companies shows equal-weighted earnings above 10%. Technology, with a 26% weighting in the S&P 500, leads all sectors with earnings growth in 3Q2017 with 23.5% year-over-year. Investors in Technology have been rewarded as reflected in the 37.1% year-to-date appreciation in the S&P 500 GICS Information Technology sector.
A recent analysis (11/11/17) by Bespoke Investment Group found that the reaction of the S&P 500 to 3Q2017 earnings has been weak, as S&P 500 stocks fell on average 0.33% on earnings reaction day. Overall, 47% of the companies reporting a positive earnings surprise had an average decline of 3.6% over the next four trading days. Bespoke concluded, based on the 0.33% decline that this is a concerning “sign.” We do not concur. With estimates moving up for earnings in 2018 and 2019, 3Q2017 earnings reports may have been already priced in prior to earnings season. Quarterly earnings are discounted. The S&P 500 rose 8.2% in 1H2017 and an additional 4% in 3Q2017. What is more interesting from the 3Q2017 price reaction is the absence of a corporate tax cut. Our conclusion that tax legislation is not priced into earnings is borne out in comments on 3Q2017 from Conference Calls of S&P 500 companies published in the most recent FactSet “Earnings Outlook.” Of the 445 S&P 500 companies, only 93 (21%) cited the term “tax reform” during their Conference Calls, and only 34 companies expressed positive sentiments.
The tax package, including a 25% tax rate for corporations in either 2018 or 2019, should increase earnings 8%-12% in the first year. The benefit of tax reduction may also result in multiple expansion. According to UBS in their November 14,2017 “US Equities Strategy” there is a value disconnect; “higher rates are priced in, higher expected growth is not.”
Estimated S&P 500 Earnings and Index
|Date||S&P 500||Earnings||Trailing P/E||% Change S&P 500|
* With an additional 10% in earnings from tax legislation and sustainable economic growth above 3%.
Source: Hutchens Investment Management.
The estimate for 2018, including the 21.0 P/E and earnings adjusted for 20% corporate tax rate, may seem outlandish. However, these estimates do not even include any repatriation of funds from abroad or benefits from individual spending from tax reform. The lowering of the rate for S-Corporations is packaged as a corporate benefit, but in essence will spur consumer spending.
Broadening of the Economy
There are numerous indications of a broadening of the economy which had begun prior to the election last year. Thus far, the current administration has ridden the coattails of an eight year recovery from a financial crisis and from a series of Fed induced stimuli. Asset prices, particularly financial assets, were artificially driven higher, but today the real economy is approaching equilibrium with many of these assets. As the economy continues to gain traction, equities in particular will lead a sustainable recovery.
Productivity – is finally beginning to increase. After nearly a decade of subpar productivity growth, there are clear signs of positive inflection. The major drivers are higher labor costs and decreased Fed stimulation, particularly the end to QE. Rising productivity has positive implications for asset prices and GDP growth. With the economy approaching full employment, the rising cost of labor relative to capital incentivizes capital investment. This trend, along with the write-off provision if passed, the tax bill should stimulate capital spending with a decided emphasis on technology.
Capital Spending – Capex, or as referred in government data, “Real Residential Fixed Investment” is showing early signs of returning to more normal business cycle levels. Historically, profit growth has led Capex by about one year. With a recovery in the 2015-2016 earnings recession in 2H2016, earnings have risen to double digit levels and are forecast to continue through 2018 into 2019. The credit cycle favors a pickup in Capex internationally, in line with synchronous growth we are experiencing today. A 100% write-off provision in the draft tax legislation, most likely with a sunset clause, may be retroactive.
Three experiences of write-off’s in the past 15 years (2003, 2009 and 2015) all led to a sharp ISM Manufacturing increase. Today, the ISM Index is at a high level and may not show dramatic rise but, with Capacity Utilization low, it is a favorable cost environment with a long runway. Also, the level of Capex with full expensing should bring on higher investment than experienced with a 50% level in the prior years. Once again, Technology should be a major benefactor of Capex.
Our investment policy remains optimistic. Fed policy is on a course of no surprises in the early stages of rising rates and in the absence of trade wars, lower taxes and reduced regulation, government policy is a positive for economic growth for the first time in nearly a decade. A selloff of not more than 5% is possible, but our view does not assume a meaningful decline resulting in a market correction of 10% or more. Going forward into 2018, the tailwinds will be better-than-expected earnings, low inflation, moderate rate increases, and strong consumer and business confidence. We expect the economy to remain above 2% annual growth in 2H2017 as slowly improving wages, housing, and Internet retail continue to reflect a healthy consumer willing to spend. It is highly unlikely given the increasing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, a successful implementation of the Fed’s balance sheet reduction, will result in increased earnings and multiple expansion giving further upside for select domestic Large-Cap Technology, Industrial, and Healthcare sectors, and selected Financial companies. Portfolios should include companies exhibiting accelerating earnings growth, solid fundamentals, expanding P/E ratios, and a sustainable business model.
David Minor William Hutchens