I’ve seen a fair amount of commentary that the stock market is overreacting to the tax bill and that stocks have gone up to far too fast. So, in this month’s newsletter, we’ll talk about the new Republican tax plan. I also want to talk about something else that I’ve seen in the market that, in my opinion, is a bit nuts, but I’ll save that topic for a special mid-December newsletter.
While we don’t know all the specifics of the final tax bill, we do know the broad outline. The tax bill has five (or six) big impact items. It contains three big tax increases. On the personal income side, two increases raise revenue by (1) repealing many itemized deductions and (2) removing the state and local tax deduction (SALT). (Some versions allow the SALT deduction for property taxes up to a certain dollar limit.) These items together are a $2.9 trillion tax increase.
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The third increase is on the corporate side. The bill allows companies to repatriate (bring back to the US) foreign cash and assets at either a 14% or 7% special one-time rate. Companies are expected to bring back enough foreign cash and assets to amount to $300 billion in additional tax revenue. Is this a tax cut bill with a weird revenue raising side? Or, is this a tax cut that costs corporations money? I have no idea into which category this part fits: tax cut or tax increase. There are also a host of other minor revenue increasing items, some of which are of dubious value, and more budget gimmicks than anything else.
The bill then has two big individual tax cuts. For individuals, the bill cuts taxes by lowering rates and increasing standardized deductions and some other items. These tax cuts are worth around $2.4 to $2.5 trillion. There are some other “add-ons,” such as repealing the Federal estate tax and repealing the alternative minimum tax. These cut another $1.1 trillion. The bill also cuts taxes for pass through businesses, which exist in a kind of half individual/half business category, worth about $600 billion.
The big tax break is the $1.5 trillion tax cut for the corporate sector. The S&P 500 (or what people commonly refer to as the stock market) accounts for about two-thirds of all corporate profits in the US. It’s probably safe to assume that around two-third, or $1 trillion, of the corporate tax cut will go to the S&P 500. This $1 trillion won’t all come at once. That figure is over a ten-year period. The net present value (i.e., adjusting it for inflation) of that amount is about $900 billion. If you believe tax cuts will be permanent FOREVER, then the value of the tax bill could be as high as $16 trillion. Of course, given the historic unpopularity of Congress, the President, and this tax bill, I’d say it’s highly likely that in 2020 the political landscape will be different. If so, we will probably see changes.
Perhaps this tax bill will last only four years. If so, then it’s worth only an estimated $380 billion.
At the start of this year, the entire stock market (the S&P 500) was valued at a little over $19 trillion. In a worst case scenario (for the stock market), if this tax bill lasts only four years it may yield a 2% gain for the stock market. If it lasts ten years, then it’s worth about a 5% gain. If you think the bill will last forever, then I guess the stock market should almost double.
The tax “thing” for companies bringing back foreign cash is worth a little more than $2 trillion, which is about an 11% gain for the S&P 500. I think, however, most investors are already banking on something like this happening. I believe a large part of the effects for this are probably already priced into the market. Indeed, the Obama administration had long proposed a one-time tax to “fund” infrastructure investments. The playbook for many companies is to hoard cash overseas to avoid taxes, wait until politicians give you a one-time tax break, and bring it back. Rinse and repeat every decade or so.
However, it’s hard to isolate the effects of tax cut in the market. This year has also been great for corporate earnings. Corporate revenue is growing around 6% year over year for the S&P 500. Corporate profits are growing at an annual pace of around 10%. It’s hard to separate out the causes of stock market gains. Which parts of the gain have been due to fantastic corporate profit growth, and which parts have been due to taxes?
I don’t think the market has gotten ahead of itself, taking into account the tax bill. We have great corporate earnings growth for the main dish and a nice little side order of 5% gain because of lower taxes. So far, everything seems within the realm of reasonableness to me. In fact, the first trading day after the Senate passed the tax cut bill the market FELL by .11%. So, I don’t see the market pricing in irrational exuberance based on tax cuts.
This tax bill is ever changing. Some of it was added in handwritten notes in the margins the night it passed the Senate. I have given you my back-of-the-envelope calculations. We don’t know the exact figures, or plan, now. So my numbers are just ballpark estimates.
My point is that the market’s behavior generally matches up with the bill. A stock market that is growing because corporate America is making a lot of money and is set to get even more money is not a bubble.
We haven’t made any drastic changes to our portfolios based on the prospect of tax reform, and here’s a good example why.
Macy’s (M) is a terrible stock. The company has under-invested in its stores over the years. As a result, they are run down and dingy. Macy’s has a lot of mall-based locations, and mall traffic is down. They also haven’t done much to expand their e-commerce efforts. (They have never really had a large online market share in the first place.) Macy’s, like many other retailers, pays close to the full statutory corporate tax rate. In fiscal 2016, Macy’s paid 35% of their net income in taxes. Tax reform will certainly benefit Macy’s; shareholders may see another $143M per year. Tax reform, however, isn’t going to fix Macy’s stores. It’s not going to magically give the company a good e-commerce strategy.
Google (GOOG) on the other hand has a really great business. Advertising dollars continue to shift online, and Google is growing net income at double digit rates. Last fiscal year, Google paid about 19% of its net income in taxes. Tax reform is unlikely really to benefit Google.
If tax reform passes and Macy’s gets to keep 15% more of its net income, then its stock should go up 15% (we are keeping our calculations simple here for example purposes). If tax reform passes, Google stock should not have a reaction to it. That’s it. Tax reform doesn’t change the ongoing prospect of either business. You aren’t going to start asking a Macy’s customer service rep to find you cheap flights to Disney World, and kids aren’t going to suddenly stop viewing YouTube videos and start flocking to malls to shop at Macy’s because corporate tax rates changed.
You’ll notice we didn’t talk about any of the economic growth effects of the bill. The reason is that growth will be minimal. As you saw with the numbers, there is not a big overall change in individual income tax rates. (Remember, about 70% of the US economy is consumer spending, so focusing on the consumer side of things is key to understanding growth.) The bill is going to add about $1.5 trillion to the deficit, and the corporate tax cut is valued at around $1.5 trillion. (Or, you might calculate $1 trillion, depending on your views about pass through businesses and your philosophical take on whether the one time foreign cash tax holiday is a tax cut or tax increase.) You are seeing almost all net new federal spending being sent right to the corporate level.
The individual tax changes are basically a fiscally neutral mish mash. Additionally, most of the benefits accrue to higher income individuals who have a lower marginal propensity to consume. Therefore, a lot of the tax cut money is not going to go back into the economy. Between 40 and 50% of the individual tax cuts will go to the top 1% of income earners. By comparison, about 30% of the Bush tax cuts went to the top 1% of income earners.
Studies found the Bush tax cuts generated about 30 cents in economic growth for every dollar of tax cuts. Since the current tax cut plan is even more heavily weighted toward the upper income tiers than the Bush tax cuts, I’d expect the fiscal multiplier for the individual income tax portion is likely going to be around .1 to .2. That means, for every $1 in net individual income tax cuts in the bill, you’ll see about 10 to 20 cents in economic growth. With about $400 to $1,000 billion in net individual tax cuts on tap, we’d expect to see about $40B to $200B in net economic growth over the next ten years. That is about .2% to 1% total increase in GDP spread over 10 years. That small a percentage increase is not enough to mention or incorporate into economic predictions about the economy.
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Article by Ben Strubel, Strubel Investment Management