by Albert Meyer
Lower consumption of cheese in 2016 caused inventories to increase. Producers responded by cutting prices. This action had the desired result. Consumers, enticed by lower prices, bought more cheese and inventories fell back to normalized levels. In fact, the increased demand for cheese at lower prices caused milk prices to go up. This dynamic interaction between supply and demand for cheese and milk all took place in an orderly fashion without interference from the “Federal Cheese Reserve.”
In a free market for capital, borrowers and lenders agree on price in response to the forces of supply and demand. Interest rates reflect the price or cost of capital. When there is excess demand for capital, interest rates rise and vice versa when demand dries up.
Unfortunately, in our capital markets, a big gorilla in the form of the Federal Reserve Bank interposes itself under the false assumption that we need a hairy and invisible hand to help us regulate the supply and demand of capital, so as to avoid excess inflation and unacceptable levels of unemployment. They make it sound ever so reasonable.
Evidently, we can be trusted to operate cheese exchanges, but when it comes to capital exchanges, we had better defer to the Fed. After all, one of the biggest players in the capital markets is the government, a menacing accumulator of enormous debt. It is no coincidence that with the help of the Fed, we had record low interest rates during a period of fifteen years when the national debt ballooned from $5 trillion to $20 trillion. If we did not know any better, we might argue that taxpayers, responsible for the servicing of this debt burden, owe the Fed a token of gratitude.
March 15, 2017, the Fed raised its target for the federal-funds rate by 25 basis points to a range of 0.75% to 1.00%. The S&P 500 surged +0.84% on the day, bringing the index within fifty basis points of its March 1 record close of 2,395.96. The first interest rate increase that followed years of rate cuts came in December 2015. Since then, the S&P 500 has climbed +15%. The market curmudgeons warned of a stock market crash once the Fed changed course.
From June 30, 2004 to June 29, 2006, the Fed raised its fed funds target on seventeen consecutive occasions. The rate increased from 1.00% to 5.25%. The S&P 500 rose +12% over the same period. The Fed began cutting rates on September 18, 2007 down to zero by December 16, 2008, during which period the stock market plunged -40%. (Reminder: history teaches us that a market recovery occurs 100% of the time. All market crashes are temporary phenomena.) From 1987 through 1989, the Fed hiked rates 27 times over 28 months, but stocks soared +26% during that time, which included the 1987 crash – case in point. From 1994 to 1995, there was a three-percentage point increase over 12 months. Stocks advanced +20% over the following six months.
Rate increases are not going to derail the market in the short to medium term. Economic data, as well as soft indicators such as confidence indices, all point to a more robust economy. Perhaps we need to hear it from a trucker, at the coal face so to speak. Here is a comment posted online, “You can feel it here in Detroit. I’m a truck driver, run auto parts, hit them all, I am dedicated to none. I hit the plants and the suppliers throughout Michigan, Indiana and Ohio. The air is different in the plants, it actually feels good to be in many of them. Prior to Trump, you could cut the air with a KNIFE. It was anger and hopelessness, that is what I felt, and I am being very serious about that. Now, things have changed, the feeling I get is a 180 from what it was just a matter of a few months ago. The guys on the dock are much more polite. The guys and gals cutting the paperwork are now actually helpful, and POLITE! I have had none of them snap at me…”
The state of the economy will drive the stock market despite the Fed’s gratuitous attempts to influence the capital markets. This is not to say that rate increases come without consequences. Those with credit card debt will feel the impact immediately. A quick Google search confirms a troubling statistic. On average, US households carry $16,000 in credit card debt. A 25-basis point increase translates into an additional interest cost of $40 over 12 months. As banks collect more income from borrowers, the frugal among us should begin to see higher rates on our savings, which currently earn us next to zero.
As the economy warms up, the demand for capital will increase. In response, the cost of capital will increase to a point where demand will taper off. The Fed, driven by fears of economic growth stalling will, as in the past, announce a cut in the federal-funds rate, which in itself becomes a self-fulfilling prophecy of economic doom. The “logical” conclusion in the media and among the intellectual elite would be that the Fed, in its infinite wisdom, obviously foresees an impending recession. Hence the need to lower rates in an effort to perk up borrowing demand – a futile exercise that distorts the natural course of economic cycles. When that happens, we can expect a major market correction. No fear, these, on average, do not last more than three to nine months.
As for now, the current bull market, albeit fairly pricey, has room to run. Time to sit down and enjoy a cheese omelet.
by Albert Meyer
According to a few financial journalists, reputable ones, mind you, the current move in the stock market is driven by “animal spirits.” After all, they stress, the bull market is now in its eighth year, which makes it the second oldest in history. In addition, considering that the average P/E on normalized S&P 500 earnings at the start of Trump’s presidency was 22.5, one pundit predicts that the S&P 500 will rise less than +10% in price by Inauguration Day 2021. By the logic of another journalist, “the market will follow the elevator and hemline fads,” as in what goes up, must go down.
Animal spirits and odious historical comparisons aside, consider the underlying factors that currently support stock prices. Let us highlight a couple. Global economic growth continues to improve, which by our reckoning makes sense. We have had almost a decade of pent-up demand. According to a Gallup poll, 47% of US workers agree that now is a good time to find a quality job. This is up from 19% in 2012. The intervention of the Fed is no longer required to keep the ailing economy on life-support. The Index of Small Business Optimism over the past three months through January jumped from 94.9 during October 2016 to 105.9 during January. The National Federation of Independent Business (NFIB) compiles this index, which has not been higher since December 2004. The index saw a similar boost back in 1980 when business owners started to anticipate that Ronald Reagan might beat Jimmy Carter. We saw a similar move when Fed Chairman Paul Volcker lowered interest rates in 1982 to revive the economy from a severe recession. Small businesses employ close to 50 million people, which accounts for 40.5% of private-sector payrolls.
This is all well and good, but nothing will play a bigger role in the stock market’s performance than the implementation of Donald Trump’s 15% corporate tax rate and the repatriation of trillions of dollars of corporate profits from abroad. We have harped on this in the past, but we are not seeing much in the shape of common sense analysis on this score. In Washington, great ideas are clubbed to death by the political process that turns everything into an “us vs. them” issue.
Politics notwithstanding, corporate taxes only raised $292.561 billion in fiscal 2016, ended September 30, according to the Tax Policy Center. Some economists who pontificate on these matters argue that lower taxes yield more revenues, and they have data to back this assertion. After all, under the scenario of a 90% corporate tax rate, most corporations would flee the country. Under a 35% tax rate, many corporations have been adept at transferring some of their profits to lower tax jurisdictions, which explains the more than $2 trillion in ready cash stored abroad.
Using approximations for the sake of brevity, a more than 50% cut in the corporate tax rate (from 35% to 15%) could cost the Treasury close to $150 billion, which equates to 4% of government expenditures in 2016. This is where politicians come in and spoil the party, especially those who argue that the tax cuts will have to be funded by so-called border taxes, or other such silly suggestions. Recall that they were quite happy to borrow trillions of dollars for wars, but now balk at funding a $150 billion shortfall in corporate tax revenues through short-term borrowing. We say “short-term borrowing” because the retention of $150 billion in the hands of corporations, the engines of economic growth and job creation, will cause tax revenues to rise considerably and make the shortfall a redundant issue. Besides, trimming a $3.540 trillion budget by $150 billion is hardly an insurmountable task. Shutting down the Department of Education, a needless duplication of functions already taken care of at state capitols, will eliminate $80 billion of the shortfall. Back in 2012, Rick Perry, our new energy czar, promised to rid the federal government of the Department of Energy should we elect him as president. Nothing is stopping him now, but don’t hold your breath.
Under a static analysis, the proposed tax cut would lower the 22.5 P/E, noted above, to 19.5. However, the impact of the restatement of the aggregate deferred tax liabilities carried by S&P 500 corporations (consider it a one-time tax forgiveness) will increase their net book value. The repatriation of foreign profits will have a further beneficial impact on the growth prospects of corporations. Our rough guess is that a speedy implementation of these tax reforms/cuts would lower the P/E to 15.0, assuming the S&P 500 index remains at current levels. However, the prospects of higher profits in future years, in the light of the cut in the corporate tax rate, could propel the index another 10% higher to the 2,600 level in the short term.
Governors and city leaders should be lining up in Washington pleading for the tax cut. On August 25, 2016, CNBC reported that in 2015 state pension funds faced a $934 billion shortfall in pension assets compared to unfunded liabilities. These funds own assets (investments) of more than $2.5 trillion. Assume half are invested in the stock market. Not counting 2016’s gains of about +10%, the introduction of the tax cuts could increase the value of the stock portfolio by more $700 billion, measured from 2015, effectively taking care of 75% of the projected shortfall. The same argument can be made for pension funds held by city administrators. Private pensions funds would also benefit. The S&P 500 corporations have more than 26 million employees. It is fallacious reasoning, as some know-nothing politicians argue, that corporate tax cuts would only benefit the rich. A drastic cut in corporate taxes would have a phenomenal impact on the health and welfare of the US population. It could change the way we think about corporate taxes, as well as the size of government for decades to come.
At current levels, the market continues to anticipate the realization of these tax cuts. For the sake of the whole country, because there is hardly a worker not exposed in some way to the vicissitudes of the stock market, let us hope that the obtrusive media and the establishment politicians, renowned for their lack of critical thinking, don’t quash our expectations and derail the stock market rally. We are facing a once in a lifetime opportunity to effect a profound change in the corporate tax structure that will reverberate throughout the economy, for the good of all.