January 31, 2018

Stocks fell sharply yesterday. There were various reasons given. There were a few earnings disappointments or at least negative reactions to forward looking guidance. McDonald’s# was a case in point. The trio of JPMorgan Chase, Amazon, and Berkshire Hathaway announced they were exploring the creation of a non-profit unit to try and lower health care costs. There were few details other than naming the representatives of the three companies, but the announcement sent the stocks of health insurers and pharmacy benefit managers into a tailspin. Some pointed to profit taking. Others noted that pension funds required to rebalance monthly had to sell stocks after a 7%+ gain in January through last Friday. Probably it was a bit of all of the above. Whatever the cause, stocks took a meaningful step down for the second day in a row for the first time since the Brexit vote in the summer of 2016. If any readers remember my 2-day rule, the decline suggests a possible sea change from the almost euphoric mood of the past four weeks to something a bit more tame. Whether yesterday was the start of a correction remains to be seen. Futures this morning point to a solid early rebound and most earnings reports this morning are supportive of a bounce. But it is reasonable to assume that January’s gains can’t be repeated all that often without extraordinarily good fundamental news beyond what we already know.

One other reason given for the 2-day decline is the knowledge that the 10-year Treasury has bounced up to 2.7%. Stocks and bonds compete for investment dollars every moment of every day. If I want to make an absurd presumption, if the 10-year Treasury yield today were 10% and all other economic factors the same, I wouldn’t be very bold to guess that a lot of stockholders would sell shares to lock in a 10% 10-year return. Of course, there is a big difference between 10% and 2.7% but you get my point. As bond rates increase, while at the same time stocks get more expensive, the temptation to move money from stocks to bonds would appear to increase.

So why have stocks soared in January even as bond yields rose? I think the answer is quite simple. Thanks to the new tax law and the decline in the value of the dollar, earnings expectations have surged more than enough to offset the rise in bond yields. The question going forward, however, is whether this trend can continue. While I previously presented a school of thought that stocks might have instantaneously reflected the benefits of the tax law change as soon as the bill was signed into law, the complexities of the changes forced investors to wait until company managements not only gave detailed guidance of the impact but also explanations of how they might invest the tax savings. That is coming out now as companies report earnings. This is the biggest week for earnings reports. That means after Friday, most of the impact of the tax law changes will be factored in to stock prices. For stocks to surge forward from here will require further good news.

In theory that could come from higher consumer spending given that a large number of Americans will begin to get more money in their pockets every week as tax withholding rates are adjusted to the new law beginning in February. Growth could also be accelerated by more investment spending. Wage increases and one-time tax related bonuses could be another catalyst. With that said, history does not support a strong linkage between tax cuts and GDP growth. While I have little doubt that there will be some impact, the jury is still out whether GDP gets bumped up by a couple tenths of a percentage point or much more. President Trump, ever the optimist and prone to hyperbole, talks of 4% growth or more with greater things to come. More sober economists are forecasting a sustained growth rate of about 2.5% or maybe slightly higher this year and next. That is a big gap. It is uncertain today which forecast is imbedded in stock prices.

There is little doubt that higher wages, more take home pay and greater investment spending are all catalysts for higher GDP. But we can’t forget that demographics push the other way. More boomers are retiring than young people entering the work force. The retiring boomers might be more productive than the inexperienced new workers. As I note often, the key to growth is productivity improvement. New products like autonomous vehicles and new concepts like artificial intelligence and blockchain hold promise to deliver significant productivity gains down the road. But these won’t even register in 2018 or 2019. What will register is the impact of crumbling roads and more traffic congestion robbing workers of productive hours and delaying the delivery of goods. Thus, there isn’t any certainty that we are about to witness a huge jump in productivity over the next year or two.

In a perverse way one factor that will help, will be the increasing difficulty companies face filling jobs. That will force companies to look for alternatives, for instance, ordering kiosks or pads to take orders instead of low skilled workers.

Immigration and trade are two other unknowns. In general, immigration is a positive for economic growth. Not only is it a positive, in many fields it is necessary to fill positions. Nurses aides are just one very obvious example. While there are no reasons, despite some of the rhetoric, to expect massive deportations, it is likely that the net number of new immigrants will decline. The question is by how much. As for trade, while I don’t expect NAFTA or any existing trade deal to disintegrate, President Trump has started to use tariffs as a weapon, a step that could lead to some level of trade war. I don’t want to speculate other than to note a concern. The new tax law may, in fact, help to improve our trade balances in a rather arcane way. In many cases, parts are made here and shipped out of the country, or vice versa, parts are made overseas to be assembled here. In a world where tax rates are dramatically different, companies have become very skilled in setting transfer pricing. Let me give a simple example to explain. If the U.S. tax rate is (or was) 35% and the tax rate in Country X is 25%, it would make sense to sell parts being exported from the U.S. to Country X where the final product is made at a low price. The low price would mean a smaller profit on the parts here (where the 35% rate would apply) and a larger profit in Country X where the final product is sold. But when the tax law changes and our tax rate is now lower than Country X, it would make more sense to raise the transfer price making a greater profit here and a lesser one in Country X. In both cases, the pretax profits are the same. Transfer pricing is the mechanism to lower worldwide taxes. We obviously don’t know yet how much transfer pricing adjustment will take place but directionally, the impact will be to raise the value of our exports and decrease the cost of imports, thus reducing the balance of payments and raising GDP growth. I suspect it could take as long as a year or maybe even a little longer to decipher the full impact.

What this all means is the following. Soon, the big boost associated with the direct impact of the tax cuts will be largely reflected in earnings estimates and stock prices. There may be some tweaking as the year goes on, but largely, the impact is now known to a large extent. The keys to the future therefore, are the forward looking growth rate in pretax earnings and the future path of interest rates. While there are clearly inflationary forces in place that should move rates higher, possibly accelerated as central banks exit their bond buying programs, there are deflationary forces in place as well, including the ongoing impact of the Internet on price discovery, any productivity improvements from higher levels of investment, and steps companies can take to battle cost inefficiencies similar to the steps I noted at the start of this Comment being taken by JPMorgan, Amazon and Berkshire Hathaway to contain health care expenses.

Right now, it looks like earnings should grow near double digits this year and at a healthy but lesser rate next year. The 10-year Treasury yield certainly seems to be headed higher. The key is the pace of increase. It won’t move in a straight line. When it accelerates, look for stocks to pause. If, for any reason, rates suddenly rise sharply (i.e. 50 basis points in a month or so), the seeds will be sown for that elusive 10% correction we have all been talking about for so long. But, on the other hand, if inflation data stays tame and rates move sideways for several months, the good economic news and better earnings will drive stock prices higher. All this suggests an upward sloping trendline with significantly more volatility than we have seen over the last 18 months. We could call that normal behavior. Corrections in a bull market and in a strong economic environment need not be feared. They get erased fairly quickly. There is a thin line between enthusiasm and euphoria that one must watch for, but I don’t see that line being crossed quite yet.

The last two days are a reminder that the stock market isn’t a one-way street. Valuations matter. In the short run, waves of optimism and pessimism can take charge. They pass over time. Facts don’t change. As always, discipline is the key. Corrections should still be looked at as opportunities. The real reason the stock market has been so good is that the economic outlook has gotten better all over the world. That isn’t a bad thought to end on.

Today, Justin Timberlake is 37. Kerry Washington is 41. Portia de Rossi is 45. Nolan Ryan turns 71.

James M. Meyer, CFA 610-260-2220

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