January 24, 2018

Stocks moved generally higher yesterday, although the Dow was held back by negative reaction to generally solid earnings reports from Johnson & Johnson# and Procter & Gamble#.

Indeed the sagas of Johnson & Johnson and Procter & Gamble may serve as a lesson for investors. Both stocks fell more than 3% after beating analyst estimates on both the top and bottom lines. But big diversified companies are (duh!) big and diversified. If a company is diversified enough and has lots of products and divisions, there is bound to be a product category or two that raises doubts. In JNJ’s case there was the legal concern about a drug that might lose patent protection sooner than expected, plus a more rapid decline than expected for a drug that has been off patent for more than a year. At P&G, the problems were poor diaper sales in China and weak shaving-related sales (they have been a problem for some time). Obviously, since both beat forecasts, there were offsetting bright spots. But in a market where soaring stock prices have discounted all things good and no things bad, reports like these set off a wave of selling. They weren’t alone. IBM# did the same last week as margins on legacy businesses came in short of expectations. In IBM’s case as well, taxes in 2018 will actually be higher than in 2017. After the close last night, both Texas Instruments and United Airlines sold off more than 3%. Almost all these stocks remain significantly higher for the year, which is just a shade over 3 weeks old, even after the post-earnings selloff.

There is an old saw on Wall Street that says buy on the rumor, sell on the news. That seems awfully apropos this earnings season. There are exceptions like Netflix yesterday where companies blow well past expectations. But the message from the first week or so of earnings is that good news has been discounted. If the only reason left to raise earnings estimates is to apply the new tax rate the company directs analysts to on the post-earnings conference call, then one might expect a meaningful pullback if all a company does is meet expectations. With that said, several of the leading banks that sold off last week have already recovered their losses and then some. IBM hasn’t recovered all its losses but has clawed back about half.

The real question is after first quarter reports are done and everyone is on the same general page when it comes to 2018 tax rates, what is going to propel stock prices forward after the reporting season is over? There are several things companies can do with the money saved as a result of tax cuts. They can reinvest in the business, spending capital to expand production or improve productivity. They can return money to shareholders through higher dividends or share repurchases. Some will cut costs to either improve or protect market share. Some will increase wages or pay bonuses to improve employee morale and retain key workers. Some will do a combination of all of the above. What we don’t know is the mix. Buying back stock or paying more in dividends reward shareholders but does little to improve overall GDP. Paying more to workers might help GDP a bit. The same could be said for increased capital investment. Multi-national companies will pay hefty taxes on earnings overseas, but it is problematic how much of that cash after taxes, returns to the U.S. in the immediate future. It is that mix of outcomes that will determine whether the tax cuts are measurably stimulative or not. History in this case is not a good predictor. Some tax cuts has been more stimulative than others. There is no doubt that the cuts will help to increase GDP growth in the short run, but the durability of any gains is the key to meaningful enhancement of shareholder value.

Furthermore, as I note often, the tax cuts aren’t free money. They will increase the deficit, and indirectly increase the supply of debt outstanding (combined with central banks moving away from quantitative easing). Thus, the single biggest key to stock market performance in 2018 is where 10-year Treasury yields will be at the end of 2018. If enough companies “invest” their savings into lowering prices and deflationary pressures of the Internet persist, rates can remain ultra low surprising most of us. But if the tax cuts stimulate an already strong economy and start to show any increased hints of inflation, combined with less stimulative behavior from central banks, there could be a bigger jump in interest rates than consensus predicts today. In that case, all the earnings growth in the world won’t be enough to offset the headwinds of higher rates. There are smart people on both sides of the debate today. At the moment, there is more conjecture than fact. As investors, facts count and the facts we see at the moment are good earnings and low interest rates. If they persist, stocks should stay on a course to move higher, with the caveat that one or more mid-course corrections are possible if stocks get too far ahead of themselves. We talk often of 5-10% corrections. In some individual cases, stocks fell by that much in a single session after a mixed earnings report.

The peak of earnings season will start today and continue through most of next week. Futures are higher today as most earnings reports are solid. GE#, which has been hit again recently by a big charge to bring its insurance liabilities back into line, posted weak results, but investors seem relieved that another big shoe didn’t drop. Its shares could open slightly higher. The big weak spot this morning will be airlines. Last night, United announced better-than-expected earnings but suggested it wanted to increase capacity 4-6%. There is no way airline demand is going to grow anywhere near that pace. The airline business is one of high fixed costs. Today, with fuel prices rising, the last thing the industry needs is more empty seats. While UAL will be down more than the other carriers, all will decline today. The airline industry is a commodity industry with only modest brand loyalty. Anytime supply grows faster than demand, prices and profits drop. It is that simple.

But away from airlines, the picture is much brighter. Banks, tech companies and health care names are all reporting strong results, excluding the benefit of taxes. The way to guarantee rising stock prices is to exceed earnings expectations. That is exactly what is happening. Investors may get too euphoric over any short period of time precipitating a modest correction, but any correction today would likely be short and reversed quickly. Stay invested but stay true to your asset allocation.

Today, Mariska Hargitay is 54. Chesley “Sully” Sullenberger is 67.

James M. Meyer, CFA 610-260-2220

Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.

Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.

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