My view that stocks are now in a bubble is further bolstered by the fact that the roughly $4 trillion dollars of global bonds still sporting negative yields (down from $14 trillion last year though the figure is rising again with German 2- and 5-year bund yields plunging back into the red) and European and Japanese central banks are still behaving as though the world is in the midst of a financial crisis. Low interest rates provide a bogus discount rate that the stock market uses to justify exorbitant valuations, creating a vicious cycle of irrationality that led to our current situation. All financial assets are trading at values divorced from their ability to generate the cash flows necessary to support them.
The truth is, investors are bidding stock prices to one record after another based on nothing more than fairy tales.
One of those fairy tales is that corporate tax reform is going to cure what ails the American economy, but when you look at the numbers it appears even Jack’s beanstalk wasn’t that big.
With all due respect to President Trump, his proposed reforms aren’t going to be nearly enough to fix our problems.
Trump Means Well, But His Hands Are Tied By Conflicting Interests
Since the election, stocks have appreciated by approximately $2.5 trillion. Yet corporations will pay only about $320 billion of taxes in 2017, suggesting that investors are discounting full repeal of corporate taxes (which isn’t going to happen) by a multiple of roughly eight times.
Throw in regulatory reform and you may come closer to this number, but by any stretch of the imagination the effects of Mr. Trump’s economic policies are more than fully priced into the market. Since corporate taxes are not going to be fully repealed and few if any corporations come close to paying the highest statutory 35% tax rate anyway, the likely impact of reform is likely to be far more muted than the market expects.
Furthermore, the road to corporate tax reform is going to be neither smooth nor simple. The border tax idea being bandied about is one of the worst ideas to appear in public policy in decades; if it were adopted (which I doubt), it would seriously harm trade and likely lead to recession.
But Democrats, still clinging to the anti-growth agenda that lost them the election, are going to fight hard to make tax reform as inefficient and ineffective as possible. Unless the Republican Party shows intestinal fortitude and doctrinal strength that was missing from its ranks for many years, we are likely to get only a watered-down version of reform that will have modest impact on the economy.
If this market rally is built on the back of corporate tax reform, it is going to collapse under the weight of its own disappointment.
Maybe we will have more luck explaining the rally if we look to repatriation of the $2.5 trillion of cash that corporations are holding offshore. With respect to repatriation of this money, some of it will be taxed by the government (maybe 10% or $250 billion), some will be used to build plants, hire workers and otherwise grow the economy (my guess is not more than 20% if I want to be a cockeyed optimist, or $500 billion) and the rest will be used to buy back stock, pay dividends and do more M&A deals, or $1.5 trillion. But that assumes that all of the cash comes back home, which is not going to happen since corporations have legitimate reasons to keep cash abroad to fund their non-U.S. operations. Let’s say that 40% of the money comes back into the U.S. That would account for about $1 trillion coming back into the market, which gets us a bit closer to the mark.
In the best of all possible worlds, if you stretch the rubber band as far as it goes, and you combine tax reform, repatriation and regulatory reform, maybe you come close to the appreciation in stock prices. But that assumes a heck of a lot, including the fact that earnings hold up, all of these new policies are actually passed, and nothing else goes wrong. In other words, you are assuming a perfect world that doesn’t exist.
Sorry about that, Mr. Trump.
We Are Far More Likely To Get A Crash Than A Continued Rally
What’s really going on, of course, is that the animals in the circus are running wild. Valuation levels are very extended with the S&P 500’s trailing P/E at 22x and the Shiller Cyclically Adjusted P/E at just under 30x versus a mean of roughly 16x. The Dow Jones Industrial Average gained 183.95 points or 0.9% to close last week at 21,005.71, its fourth straight weekly gain.
While the superlatives go on and on, there is just one problem: Valuations may be supported by hope but are unsupported by economic fundamentals or earnings. The only numbers that are off the charts are sentiment indicators that are usually signals to run in the other direction (which is what sensible people do when animals are charging at them). Investors Intelligence’s (II) highly respected polling shows bulls at 63.1%, the highest reading since 1987. This number has been above 55% for 14 straight weeks, which II calls the “danger zone.” Bears were down to 16.5%, the lowest figure since July 2015, putting the bull-bear spread (i.e. the ratio of how many people are bullish to how many are bearish) at 46.6%, the highest for the current cycle and another contrarian indicator. But technicians are divided; for every one warning that markets are overextended, you can find another one saying they can run further.
The truth is that nobody knows what the immediate future holds. All we can know for certain is that stocks are trading at the very upper end of their historical valuation range and that returns from such levels tend to be lower than returns from lower entry points. With stocks like ExxonMobil (XOM) trading at 44x earnings, investors really need to ask themselves why they are partying like 1999 when Prince is dead, Corporate America is more leveraged than a decade ago when it was heading into the worst financial crisis since the Depression, the global economy is grossly overleveraged, and the geopolitical landscape is as fragile as it’s been since World War II (though the Russians aren’t coming, trust me). Denial is not an investment strategy.
However, if you are looking for some good short ideas, you can find them here, here, and here.