By David Nelson, CFA
After a 6 week slide from the all-time intraday high of 2400, the S&P 500 (SPY) rallied in the final two weeks of April hoping to retake the high ground.
The tug of war between valuation, politics and macro concerns vs. a relatively strong earnings season rages on. While the CBOE SPX Volatility Index (VIX), a measurement of investor fear sits near 52 week lows, I suspect the rolling correction of stocks as traders jump from one sector to the next masks the real volatility of individual securities.
Fund managers as well as retail investors all know the pain of a stock gaping to the downside following a poor earnings release. The three worst performers in the S&P 500 last week included Synchrony Financial (SYF), Seagate (STX) and Ryder (R) down between (-12%) & (-17%). That sounds like volatility to me.
Macro vs. Micro
While there’s been good news from individual companies, the macro picture struggles to make serious headway. The gulf between hard and soft data continues. Post the election, consumer sentiment and survey numbers (soft data) continues to be resilient. However, Friday’s GDP coming in at 0.7% was another reminder that there’s still a lot to be done to accelerate an economy growing at just 2%.
Frankly a sustained 3% economy would be a home run and make no mistake that’s a major undertaking. After the administration’s stumble in healthcare the conversation has shifted to tax reform and trade.
Can Tax Reform Boost Stock Prices
Before I go into the details, let’s de-politicize the conversation focusing on the fundamentals. I realize our client’s and followers come from both sides of the political spectrum so let’s turn the discussion to the probability and economic outcome of the current tax reform package.
The most important piece of the proposal is an attempt to cut the corporate tax from its current 35% down to just 15%. This is surely an opening bid and I believe the administration would be happy with 20 possibly even 25%. While most corporations don’t pay the headline number even the reduced rates paid aren’t competitive so it isn’t surprising that many structure their world operations in a manner to direct cash off-shore some even changing their base of operations to tax friendly countries.
Like most things in life the devil is in the details which at this point are still lacking. It’s early in the process but a question being asked that has to be answered is the following:
“Will there be legislative language to help avoid a rush of individuals looking to incorporate perhaps forming LLC’s (Limited Liability Corporations) to take advantage of the lowered corporate tax rate.”
Without it, the potential to game the system is high and could balloon the deficit even further.
Earnings Boost?
For investors, here’s where the rubber meets the road. Estimates from economists regarding just how much of an earnings boost companies get on the heels of a proposed tax reform package vary widely and by itself not surprising since the lack of detail makes it difficult to score. However, most economists agree there would be an incremental boost to the bottom line. In addition, repatriation and a potential 10% tax holiday would go a long way to bring back cash held off-shore that could be used to fund capital expenditures or buy back stock.
Stock Buybacks have slowed
It’s interesting with so many pointing out the benefits of increased stock buybacks under a Trump tax-reform package, CEOs are starting to turn their back on the idea. In a note published last week Goldman’s (GS) economic team headed by David Kostin discuss the 20% decrease in buybacks this year vs. 2016. Authorizations are down as well so it’s clear something has changed the calculus.
This could easily be a valuation call with CEOs just finding their shares too expensive. History shows that buying back stock at extreme levels is a no win situation. Cisco (CSCO) was the poster child of this type of behavior 20 years ago and suffered for it the following decade.
As a strategist, portfolio manager and frankly as an American it’s my hope that any additional funds finding their way to the corporate balance sheet be it from tax cuts, repatriation, whatever are used for something more than just another round of stock buybacks. It’s imperative that CEOs and management think beyond the quarterly earnings report merry-go-round. Every dollar added to CAPEX is an investment in the company’s future and with it an investment in America.
*At the time of this article some funds managed by David Nelson were long SPY
