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How Tax Cuts Could Impact Apple Inc.

by Albert Meyer

The stock market turned strongly positive after Donald Trump won the presidential election. Expectations of a drastic cut in corporate taxes largely account for this phenomenon. Trump’s tax reform also includes proposals to encourage the repatriation of foreign profits. Most US companies with overseas profits judged the corporate tax rate of 35% too punitive and made the rational decision to keep the funds abroad. In some cases, these foreign earnings are invested in US Treasuries, but this does not qualify them as repatriated earnings.

Based on market capitalization, Apple is the most significant US company with extensive operations abroad. Under Trump’s Sept. 27 Tax Reform Framework, Apple’s worldwide profits, most of them based in Ireland, where the corporate tax rate is 12.5%, would be taxed at 20%, with a credit for foreign taxes paid. The objective of the new rules is to remove the incentive for companies to flee to tax havens. Also, unremitted foreign earnings that have accumulated overseas under the old system will be treated as having been repatriated and won’t be liable for a repatriation tax.

All things being equal, and even if pre-tax income register no growth, the corporate tax cut will save Apple $3.1 billion and add $0.60 per share to the company’s fiscal 2018 earnings. At a valuation multiple of 18.1, a $3.1 billion tax saving translates into an approximately $55 billion impact on the company’s market cap.

Apple provides deferred tax on about half of its unrepatriated foreign profits, which makes it somewhat unique among its peers. For example, the effective tax rate for Microsoft and Alphabet averaged 19% over the past three years. For Apple, it was 26%. The difference is Apple’s conservative approach to unremitted foreign earnings. Consequently, the company has a $31 billion provision for deferred taxes on unrepatriated profits which under the new framework would in their entirety be exempt from taxes.

A $31 billion reversal of the provision, with an offsetting adjustment related to deferred tax assets in fiscal 2018, will provide a boost to EPS of $5.25 per share. Understandably, analysts would ignore this one-time non-cash item, except for the fact that it would add $5.25 to the company’s book value per share of $25.71, an increase of +20%. Apple currently trades at a price-to-book value of 6.1. Regarding Apple’s market cap, this translates into $165 billion, or $32 per share.

One should not conclude from this that if the tax reform proposals become law, that Apple’s market cap would go up by approximately $220 billion (the sum of the lower tax rate on current year profits and the deferred tax adjustment). The increase in Apple’s market capitalization from $590 billion a year ago to the current $810 billion is almost entirely attributable to expectations of a tax credit and an elimination of the repatriation tax on foreign earnings.

Instead, if Congress fails to meet investor expectations, Apple’s market value could decline by approximately $220 billion, with the broad market following suit.

The levying of taxes on corporations destroys capital. The capital destruction is approximately equal to a company’s tax burden times a company’s price to earnings ratio. Washington takes $3.1 billion, and Apple shareholders suffer a $55 billion hit. A better way to raise revenues would be to exempt corporations from income tax, but then tax dividends and capital gains at a 25% rate with a deduction of only 50% on short-term trading losses. To soften the blow, levy a one- to two- percent tax on global revenues to the equation. A revenue tax would eliminate the need for a corporate tax code and release the brain power of tax accountants for more productive endeavors. Capital allocations decisions should be based on cold logic rather than be distorted by tax code intrigue.

On October 17, 2017, Treasury Secretary Steven Mnuchin warned that if tax relief was not enacted, “you’re going to see a reversal of a significant amount of these gains.” The above analysis confirms Mnuchin’s fears. Enact, or DOW 18,000 here we come.

Why are governors and mayors not storming Washington on hands and knees begging for the lowest possible corporate tax? The public pension funds of state and local governments are apparently dealing with unfunded pension liabilities amounting to $2 trillion based on an average 7% compound return. Significant tax relief would go a long way to deal with the problem of unfunded pension liabilities, not to mention the millions of Americans with retirement accounts heavily invested in the S&P 500 and other equities.

Corporations are the engines of growth, job creation, and innovation. Corporate taxes only yielded revenues of $350 billion, or 9% of total expenditures in fiscal 2016. Apart from practicing fiscal discipline, Washington ought to raise revenues without resorting to the destruction of capital.

Q3 2017: To Tax or Not to Tax…

by Albert Meyer

To be, or not to be, that is the question – Hamlet, Act III, Scene I:

Pundits complain, perhaps not without reason, that the stock market’s relentless surge is puzzling considering the impending interest rate hikes, stalemate in Congress, geopolitical events that could turn ugly in the “fire and fury” sense of the word, and other crises that could erode investor confidence. For now, investor confidence is driven by the prospect of tax reform, regulatory relief, and the euphoria that brokerage statements evoke these days. Those who missed out by paying too much attention to the doomsayers are starting to throw caution to the wind and their sudden arrival at the trading desk, late in the day, adds to the buying frenzy.

Our non-market timing approach, or invest-for-the-long-term strategy, has paid off. Our composite portfolio (all clients in the aggregate) gained 15.97% year-to date and 19.75% over the past 12 months. This is despite the fact that the composite holds more than 15% in cash due to new client additions, a number of stocks that were sold pending takeover offers, and a couple of rebalancing trades. Dips have worked well for us in the past, but since Donald Trump’s improbable coup last November, there have been no dips to buy. The stock market has experienced 15 drawdowns since 2009, but none since the third quarter of 2016. A brief correction is just a matter of time. Economic fundamentals both in the US and abroad favor continued global economic expansion.

We have been unapologetically bullish since 2009, cautious, but bullish. We steadfastly allocated cash to equities in a slow and deliberate manner. There is no substitute for being invested over the long term in the stocks of the world’s best companies. It is the power of compound interest, as Warren Buffett always reminds us, and the eighth wonder of the world, according to Einstein. Fundamentals could change on a dime, when fear takes over, so patience remains the watch word. If and when the market corrects, do not panic, no matter how long it takes to turn positive. Long-term investors must stay the course. We would welcome a pullback in the market. We are ready to put our cash holdings to good use.

Tax Cut Expectations

The stock market enjoyed a “Trump bump,” since Donald Trump’s election, in anticipation of corporate tax cuts, infrastructure spending and regulatory reform. This is misguided optimism, some would argue, and with some justification if we consider legislative failures on many fronts.

Warren Buffett is reportedly upbeat on prospects of tax cuts despite congressional Republicans failure to repeal Obamacare. “I would think with Republicans controlling both houses and the presidency, they would not have a shutout in their first year,” Buffet told the media. Buffett feels that the tax proposals are relatively uncomplicated and could potentially be bipartisan. “I think they can get it done. It’s not a tax-reform act, it’s a tax cut act,” he said, adding characteristically that “any politician that can’t pass a tax cut is probably in the wrong line of business.”

The media’s response to Trump’s tax proposals were predictable, namely, a “huge windfall for the wealthiest Americans and no direct benefit for the bottom third of the population.” Reference to the “bottom third of the population” in a discussion of federal tax policy is a non sequitur. According to the Tax Policy Center, an estimated 45.3% of American households (roughly 77.5 million) pay no federal income tax. They might well be paying state taxes, and of course, the punitive social security taxes. About half of the 77.5 million have no taxable income, and the other half enjoy generous refundable tax credits and other breaks.

The top 1% of taxpayers (average income of $2.1 million) pay 43.6% of all the federal individual income tax at an effective income-tax rate of around 23%. Consider also that the top 0.10%, a mere 115,000 households, whose average income is more than $9.4 million, account for 20% of individual income tax receipts. Raise a glass and toast these households. Should we not be immensely grateful for the huge tax burden they carry on behalf of us all?

The richest 20% of Americans cough up 87% of all the income taxes the Treasury collects. The middle-income group contribute less than 5%. The 20% between the middle-income group and the top 20% contribute 13%. The bottom 40% garner 5% of these revenues in tax credits. Please tell the media, there is “no bottom third” in the tax realm.

When counting all federal taxes (individual income, payroll, excise, corporate income and estate taxes), we find a broader distribution. Excise taxes constitute taxes on gasoline, alcohol and cigarettes, which most people pay. On this basis, the 20% richest people pay 69% of all federal taxes in America. Any tax cuts would by force of circumstance benefit the wealthy among us, but the politically-charged media willingly ignore such pesky facts.

Some pundits argue that tax reform has never changed an economic cycle in the past, because tax revenues as percentage of GDP, regardless of changes in tax rates, have persisted at a ratio of 18% of GDP for over 60 years. One pundit used this fact to argue that tax reform would make no difference, “total taxes collected by the government are extremely likely to be the exact same.” Consequently, expectations of tax reform driving the stock market are unfounded, he argues.

But the current proposal, with its emphasis on cutting corporate taxes is different.  A meaningful cut in the corporate tax rate could induce corporations to conduct more of their business operations in the US, reversing the outsourcing trend. If that were to happen, the Treasury should collect a lot more revenues. At the same time, increased business activity at home will boost GDP and when everything is tallied, tax collections will equal 18% of GDP, considerably more than the current gross collections.

Over the past 60 years, the marginal rate tax rate for individuals has been as high as 90%. It is currently at 39.6%. Nonetheless, personal tax as a percentage of total taxes has remained flat at a ratio of roughly 40%. Corporate taxes as a percentage of total taxes have declined from 32% in the early 1950s to the current 9%. The 40% ratio is deceptive, because individuals’ social security taxes contributed 10% of tax revenues in 1953, but through a successive series of tax increases, the contribution is now 35%.

Destruction of Capital and Wealth

The levying of taxes on corporations destroys capital. The capital destruction is approximately equal to a company’s tax burden times a company’s price to earnings ratio. If the S&P 500 companies remit in the aggregate $200 billion a year to the Treasury and their average P/E is 20, we are looking at a $4 trillion blow to their combined market capitalization. Washington takes $200 billion, and shareholders suffer a $4 trillion hit.

Corporate income taxes make up about nine percent of Federal revenues. Altogether, these revenues financed more than $3.3 trillion of the $3.9 trillion that the government spent in fiscal 2016. In dollar terms, corporations contributed $351 billion to the Treasury in fiscal 2016.

Cutting the corporate tax rate from 35% to 15%, would reduce the contribution made by corporations to the Treasury by approximately $200 billion. At a tax rate of 20% the tax relief would amount to about $150 billion.

This being so, any hesitation or lowering of expectations on the corporate tax front could plunge the stock market into a 10%-plus correction in a hurry. Alternatively, if Congress settles on a 20% rate, the stock market might struggle to eke out any further gains for the rest of the year. It is doubtful our lawmakers have an inkling of how critical it is for the overall financial health and wealth of all components of the US economy to pass tax reform ASAP and lower the corporate tax rate to 15% (preferably zero). This decline in corporate tax rates is a global phenomenon, driven by the competitive nature of globalization.

Public Policy Implications

Having illustrated the impact of tax cuts on the market values of companies, it is mystifying why governors and mayors are not storming Washington on hands and knees begging for the lowest possible corporate tax.

As we write, media sources report that Kentucky’s public pension fund is underfunded by approximately $42 billion to $84 billion, depending on assumptions used to calculate the deficit. It is not difficult to see why the unfunded pension liabilities for all state and local governments is currently reported as $2 trillion based on an average 7% compound return. Major corporate tax cuts could boost the S&P 500 by another 25%. This would go a long way to deal with the problem of unfunded pension liabilities, not to mention the millions of Americans with retirement accounts heavily invested in the S&P 500 and other equities.

There is another imperative: job security. The S&P 500 companies have more than 22 million employees on their payrolls. At a bare minimum, tax cuts will improve the financial health of these employers, and this will give their employees greater job security. The same logic applies to the other 6,000 public companies, and an untold number of private company employers.

What about job creation? We have written about this in the past, but if the government can create x number of jobs with $10 billion transfer of taxes to the Treasury, how many more jobs can the retention of those taxes in the country’s engines of economic growth create? If we say the answer is y number of jobs, and if y > x then the less cash that corporations send to Washington the better. If x > y, the Soviet Union would have been an economic paradise. (In truth, the government does not create jobs. It is another one of those urban myths, along the lines of Frederic Bastiat’s “Broken Windows” fallacy.)

Funding Bloated Bureaucracies

A more pertinent point would be to question why any American should forfeit 35% of his or her income, plus another 7.65% in social security taxes on the first $127,200? If we limit government expenditures to 15% of GDP (preferably lower), the top marginal rate would not have to be above 20%. That’s how they run their government in Singapore, where GDP growth has averaged 8.25% p.a. the past 55 years. The current growth rate is 6.3%. Singapore does not skimp on defense spending, despite the frugality of their government. Singapore spends 3.6% of GDP on defense, a tad higher than US spending of 3.3%, and a lot higher than average of about 1.5% for most European countries. Singapore pegs government expenditures to GDP growth at an average ratio of 12%, currently running at 10.5%.

There is a lot we can learn from Singapore was the observation of China’s President, Xi Jinping (with a PhD. in economics and law), after a visit to that country a couple of years ago. These are not just words, they were followed by action. China has trimmed government spending to 14.0% of GDP from a high of 16.6% in 2000. Of course, nothing beats Hong Kong’s stellar record with government expenditures comprising 4.8% of GDP. Hong Kong boasts a ten-year GDP growth rate of over 5% p.a., but this rate tracked well above 10% p.a. prior to 2005.

If tax revenues as a percentage of GDP are unlikely to ever increase, what are the chances of a decline in government expenditures relative to GDP? With the national debt ballooning to $20.3 trillion from about $5 trillion back in 2000, Washington is spending way more than it collects in tax revenues. Spending on entitlements, including social security, plus interest payments on debt are running close to 100% of tax revenues. Hence, the argument that tax cuts generate economic growth is nullified if tax cuts lead to increased deficits and debt. Increased debt means increased deflationary pressure, which translates into slower economic growth.

From 1950 to 1990, we counted 17 years (more than 40% of the time) during which economic growth exceeded 9.0%, and only 5 years below 5%. We haven’t seen a year with double-digit growth since 1983. Growth in the last decade of the 20th century, averaged 5.58% p.a. Then the national debt started piling up, and growth declined to an average rate of 3.90% since 2000. (These growth rates are not adjusted for inflation.) During the same period, the national debt grew at a rate of 8.59% p.a.

Unless tax reform is accompanied by spending cuts, there will be no positive economic benefits accruing over the long term. Clearly, Congress will not cut entitlement and defense spending. The ever-increasing interest burden (more so if interest rates were to rise), is also unavoidable. On the other hand, there are government departments that are redundant at the Federal level. Considering that every state in the Union has its own Department of Education, there is absolutely no need for another $83.3 billion behemoth in Washington, duplicating much of what can be taken care of at state level. Prior to Jimmy Carter’s presidency, the country managed quite well without this nonessential bureaucracy.

There are other departments floating about in Washington of similar redundancy. Add them all up and their annual budgets might well exceed $500 billion. Bring the troops home and there you have it, perhaps a trillion-dollar cut in spending. As this is all highly unlikely, perhaps setting a target to cut all departmental budgets by 3% to 5% toward an ultimate goal of limiting Federal spending to 15% of GDP, could achieve lasting economic benefits.

Even though gridlock in Washington places tax reform in jeopardy, President Trump could bypass the GOP and make a deal with the Democrats. Cut taxes for corporations and the middle-class, but retain estate taxes and increase tax on dividends and capital gains. Taxing dividends and capital at a higher rate, say, 25%, would shift the tax burden to shareholders, which those on the left, who want “to soak the rich,” might see as a sensible compromise. We would be in favor of a higher tax rate on dividends and capital gains, but then cut corporate taxes to zero, or perhaps substitute for a 2% tax on global revenues. Eliminating estate taxes, which hardly anybody with proper tax planning pays, is a politically charged issue.

Of course, nothing is simple and straightforward in Washington. We fear that a 20% corporate tax rate (still much too high for us), will be accompanied by all kinds of tax incentives and mandates. For example, a provision that would allow the immediate expensing of capital expenditures to encourage investing in capital equipment, might garner some votes and campaign contributions, but it could lead to the misallocation (mal-investment) of capital mainly spurred by tax considerations rather than cold economic imperatives. The less influence the tax code has in the boardroom the better. Regrettably, in practice, the purpose of the tax code is to capture the attention of special interests to be milked for campaign contributions.


Since 2009, the market corrected by more than 10% on five occasions: Q2 2010 15.99%, Q4 2011 19.39%, Q2 2013 9.94%, Q3 2015 12.35%, and Q1 2016 14.1%. From 2009 to Q4 2014, we have had 10 drawdowns ranging from 5.44% to 8.13%, six of these took place during 2009 to 2011 (three years) and four during 2012 to 2014 (three years). There were no minor drawdowns in 2014 and 2015, but the market experienced corrections of 12.35% and 14.16% in 2015 and 2016. We have now gone 19 months without a correction or minor drawdown since February 2016. Prior to that, we had some form of a pullback on average every seven months, but with more regularity earlier in the recovery following the 2008/9 recession.

Despite the drawdowns, long-term investors who did not participate in any panic selling since 2007 are looking at stellar returns, even if they were fully invested at the market’s previous high on October 9, 2007. Market returns varied, depending on the composition of one’s portfolio. The three top performing sectors of the S&P 500 since October 9, 2007 were consumer discretionary (+143%), healthcare (+126%) and consumer staples (+90%). The technology sector, which serves the consumer sectors in one way or the other, rose by 144%.

On the other hand, there were underperforming sectors, namely, industrials (+60%), materials (+35%), utilities (+29%) and real estate (+14%). Financials took a real beating and were down by 10% from 2007 to 2017, but they rallied strongly in recent years. Energy remains depressed with returns down 14% since October 9, 2007. Private nonresidential fixed investment as a percentage of GDP has not recovered anywhere near its previous peak. Our corporate tax rate has encouraged US firms to make capital investments in plant and equipment in countries with very low tax rates.

Legendary investor, Peter Lynch, said, “There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.”

Fed’s “Invisible Hand”

During the current economic expansion – expansion should not be taken too literally – the Federal Reserve’s not so invisible hand contributed growth, or at least influenced the level of overall confidence, via its “Quantitative Easing” programs. In case we need a reminder, we had maturity extension programs, bailouts of Bear Sterns, AIG, GM, banks, TARP, TGLP, TGLF, HAMP, HARP and others. We remember the acronyms but have forgotten what they all stood for. Those who keep track of the numbers tell us this economic support tallied $33 trillion. All this financial engineering produced growth of $2.64 trillion in GDP, or a parsimonious 16.7% since the beginning of 2009. Economist Lance Roberts, points out that $12.50 of the Fed’s interventionism produced $1.00 of economic growth. Another sobering fact is that real (inflation-adjusted) median net worth of US households has only recovered to 1995 levels. Alarmingly, there has been very little growth in real net worth since 1989 if we excluded the top 10% of income earners. According to a Fed survey, median household before-tax incomes have fallen from near $55,000 in 2004 to roughly $53,000. This statistic got as low as $48,000 in 2013, which does create a post-recession illusion of income growth.

An analysis of the 2016 Survey of Consumer Finances, available on the Federal Reserve’s website shows a complete lack of economic improvement in all respects, other than for the wealthiest 10% of people in the country. The survey covered growth in incomes, growth in net worth, growth in investable assets/securities, retirement accounts, and the value of business equity,

This wealth divide was nurtured by policies implemented by current and past administrations. The unending interventions of the Federal Reserve had its desire effect. The top wealthiest 10% walked away with the spoils, while the majority of households show little improvement in incomes retirement and other financial assets.

David Stockman, who served in the Reagan Administration, points out that among the 148 million income tax filers, the bottom 53 million owed zero taxes in the most recent year (2014), and the bottom half (74 million) paid an aggregate total of just $45 billion.

By contrast, the top 4% or 6.2 million filers paid $802 billion in Federal income taxes. That amounted to nearly 58% of total Federal income tax payments.

Stockman argues that despite the media’s hype about the rise of the stock market, what we miss is that after two devastating bear markets, many families no longer have the capacity to participate. On his normal pessimistic note, he writes that, “the structural transformation that has occurred in recent years has likely permanently changed the financial underpinnings of the economy as a whole. This would suggest that the current state of slow economic growth is likely to be with us for far longer than most anticipate. It also puts into question just how much room the Fed has to extract its monetary support before the cracks in the economic foundation begin to widen.”

A common misconception is that the Fed printed trillions of dollars to avert a deep recession. Money, by definition, comprises the sum total of M1 (cash in your wallet or checking account) and M2 (near money, cash deposits in savings, money market accounts). The Fed increased the reserves of banks to enable them to loan out these excess reserves, at which point money (M2) is printed or created.

However, a relatively small portion of these reserves made it into the money pool via bank loans. The rest were retained as excess reserves. Had the banks engaged in aggressive loan activity, serious inflationary pressures would have ensued. In reality, the public was hesitant to increase their leverage, the velocity of money remained low, inflation never materialized and prolonged anemic economic growth followed. Currently, the supply of money, remains well within historical levels.

The money multiplier indicates the rate at which banks create money from reserves. Surprisingly, the rate has been in a slow decline for decades. Experts tell us that this signifies a structural weakness in our economy, as confirmed by a notable decline in the growth rate. We have not seen a double-digit growth year since 1983. As Eric Basmajian at EPB Macro Research explains, “There is ever weakening demand for loans each and every year that reduces the money multiplier, making each and every marginal dollar of reserve increase (quantitative easing) less and less effective as that marginal dollar will not be transformed into money.” What is behind this phenomenon? The demand for loans decreases annually, depressing the money multiplier and minimizing the impact of quantitative easing ineffective, because over the decades ever-increasing debt levels, both public and private, have almost reached saturation point where a debt problem can no longer be solved by adding more debt. This phenomenon is not unique to the US, but virtually every developed country nation grapples with the same problem.

The expectation that a dramatic increase in banking reserves would lead to a marked increase in loan activity with a concomitant increase in money supply and inflation to reverse the long-run deflationary spiral has remained unfulfilled.

In addition, as pointed out earlier, a massive increase in the size of government expenditures relative to GDP has exacerbated the slow economy growth environment. An internet search will provide ample evidence of this, but our inclination was to look up the data for France first, a country that, like most in Europe, offers its citizens a vast array of government services and support from cradle to the grave. In 1978, the ratio of government expenditures to GDP was 44.9%, still way too high to our liking, but that was so much better than the current ratio of 56.2%, a tad lower than 2014’s 57.1%. In South Korea and Switzerland, the ratios are 32.3% and 33.6%, respectively. For the Eurozone as a whole the ratio currently runs at 47.7%.

Velocity of Money

It matters not how many dollars the Fed pumps into the economy if these dollars lie dormant in bank vaults due to lack of demand. Money needs to circulate to make a difference. Stated differently, an acceleration of business activity increases the velocity of money. And yet, velocity on M2 remains at levels not seen since 1949.

Since the peak in the third quarter of 1997, velocity has fallen from 2.21 in 1997 to 1.43 today, a reduction of 35%. Lethargic GDP growth offers confirmation of this dismal statistic. GDP has grown at a rate of only 2.2% p.a. since the 2009 recovery. As noted, experts who watch these numbers closely argue that debt is deflationary. With household and national debt at record levels and velocity anemic, any hopes of 4% GDP growth are a pipe dream. Extremely low wage growth, for decades now, but more acute in recent years, means that the ability of households to add more debt to their already highly leveraged situation is fading fast. If we listen to these pundits, most prominently those who always think the stock market bubble is about to burst, the 3.1% GDP growth in the second quarter of 2017 was an aberration. The current third quarter should see a decline below 3% and anything above 3.5% for the fourth quarter is highly unlikely, with 2018 much of the same slow-growth environment.

Recession Watch

As always, we consult those who monitor the relevant data that are supposed to predict an impending recession. Research firm, iMarketSignals has an economic model based on employment numbers that does not currently indicate an imminent recession.

The yield curve supports this notion. The spread between the 10-year (2.36%) and 2-year (1.54%) Treasuries stands at 0.82%. Recession concerns will take center stage if the spread were to tighten to 0.35%.

Currently, the Fed’s “Yield Curve” model shows a 10.3% probability of a recession in the US twelve months ahead. For comparison purposes, it showed a 10.0% probability through August.

The second model, closely watched by the Fed, was developed by Marcelle Chauvet and Jeremy Piger. This model is described on the St. Louis Federal Reserve site as follows: “Smoothed recession probabilities for the United States are obtained from a dynamic-factor Markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales.” This model currently shows a 0.18% probability of a US recession using data through July. Economists participating in the September 2017 Wall Street Journal Economic Forecast Survey placed on average a 16.08% probability of a US recession within the next 12 months.

The Business Cycle Index (BCI) currently shows 227.2, above the previous week’s 226.6 reading, and confirms no recession looming. The BCI was designed for a timely signal before the beginning of a recession. Those who back tested the BCI assert that the index would have provided reliable warnings for the past seven recessions. The BCI at 228.1 is at a new high for this business cycle. In addition, the six-month smoothed annualized growth BCIg is at 13.1, which is above last week’s 12.9. No recession is signaled. The BCI incorporates the components of seven indices. When the BCIg falls below zero, we can expect a recession within three months. There are variants to the BCIg that provide warnings six months ahead of time.

Notable Indices

There are two important indices that track the health of our manufacturing sector and both are showing modest increases. The first of these, the US Manufacturing Purchasing Managers’ Index (PMI), for September came in at 53.1, up from August’s final reading of 52.8. The second PMI index, published by the Institute of Supply Management, registered 60.8, a 2.0% increase from the previous month’s 58.8. A notable component of the index, the New Orders Index, posted an increase of 4.3%. The Supplier Deliveries Index registered a 7.3% increase from August. The Prices Index posted a 9.5% increase from the August, level of 62, signifying higher raw materials prices for the 19th consecutive month. New exports increased 1.5%, while imports registered a 0.5% decline. Purist consider the ISM Manufacturing index with skepticism, on the grounds that it is a diffusion index that reflects the number of purchasing managers surveyed reporting either better or worse conditions, without any recognition or weighting of respondents based on the size of a manager’s firm. Be that as it may, we pay more attention to the overall trend, rather than precise numbers.

The Institute of Supply Management (ISM) also publishes a Non-Manufacturing Purchasing Managers’ Index (PMI), also known as the ISM Services PMI. For the month of September, the headline Composite Index is at 59.8%, up 4.5% from 55.3% last month and its highest level since August 2005’s 61.3%. This represents continued growth in the non-manufacturing sector at a faster rate.


The September jobs report compiled by the Bureau of Labor Statistics (BLS) indicates that the loss of 33,000 jobs was mainly due to the impact of hurricanes on Texas and Florida. IHS Markit (Information Handling Services) estimates hurricanes reduced employment by 249,000. The consensus estimate was for an increase of 100,000 jobs. The BLS revised the last two months of data down, confirming that there is a slight deceleration in employment growth as a consequence. This ought to be expected considering the low unemployment rate.

Recall that in July 2005, nonfarm payrolls gained 369,000, but after Hurricane Katrina in August, the job gains were 195,000 and 63,000 in August and September, respectively, but by November monthly gains were over 300,000 again.

The unemployment rate dropped to 4.2% from 4.4% and the underemployment rate to 8.3% from 8.6%, in both cases registering cyclical lows. The participation rate, which shows the share of working-age people who are employed or actively looking for work, rose to 63.1%, the highest since early 2014. The prime-age participation rate, covering people ages 25 to 54, matched July as the highest since 2010.

Year-over-year growth in hourly earnings jumped 0.5% in September to 2.9% (from $25.81 to $26.55 per hour), the strongest pace since June 2009. There is reason not to cheer this number too enthusiastically. The inclement weather boosted the overtime pay of utility workers. The bump could also be explained in terms of the extent to which workers in low-pay sectors, such as hospitality and leisure, were temporarily out of the job market.

The Labor Department also keeps track of part-time workers, those who work less than 35 hours a week. In 1968, when the Department began collecting this information, only 13.5% of the US workforce were part-timers. This statistic peaked at 20.1% in January 2010 and currently runs at 17.9%.

Economic Data

There are those who argue that advances in technology have so changed the economic landscape that government statistics are not keeping track of all economic transactions and trends, because they are not readily apparent. They concur that debt and bloated governments have placed deflationary pressure on global growth, but the low growth rate in recent decades can also be attributable to an underground economy, not necessarily illegal, that goes unnoticed by the fact gatherers. The advent and greater acceptance of cryptocurrencies will accelerate this trend. If economic growth is stronger than official data indicates then equities might not be as overvalued as they currently appear. The debate is ongoing.

A Year Ago

This time last year was a time of great angst, with the Presidential race dominating the news. The prognosticators of doom and gloom were out in full force. We made light of their attention-seeking predictions:

“Permabear Albert Edwards, the global strategist at Société Générale argues, ‘If you’re buying stocks today, you need a psychiatric evaluation.’ Edwards told MarketWatch in an early September interview that the stock market, bolstered by easy money, has valuations at “nosebleed” levels even as labor costs are rising and corporate profits are falling.

“There are many more reasons than ‘easy money’ for the stock market’s double-digit return over the past 12-months, but we will not confuse the issue with niceties. As we noted above, a positive surprise awaits the bears on the profit front this quarter. In addition, last year’s strong dollar and the slump in energy prices had a negative impact on earnings, which makes for an easy comparison over the next 12 months. It won’t take much to beat last year’s earnings, so the profit decline is just another wild guess.

“Edwards says that the US economy is on the brink of recession; no, it is not even close. After that build up, Edwards, who is based in London, warns that the ‘S&P 500 is set to plummet to 550.’ Edwards is trying to scare us into a 75% market decline…

“’It is madness, what we are seeing,’ said Edwards. The coming crash, he said, ‘will be horrific compared with what we’ve seen so far…’

“A financial writer and pundit whom we respect opined back in April 2015 that, ‘the stock market could be ‘sort of scary’ this year… because a significant sell-off is on the way, owing to sentiment being too rich in US markets. Often when sentiment is extremely high, like now, it makes markets vulnerable because investors are complacent, and there are fewer people left to buy your stocks and drive them higher…’ The market actually did sell-off, gradually mind you, but staged an impressive rebound in October 2015, then swooned again in January and February 2016. From April 2015 to February 2016, the market was down -10.6%. There is nothing scary about that, more so, as it rallied 16.03% from the February low to the close at the end of September 2016. It took less than two months to get above April 2015’s high, which meant that those who sold fearing the impending sell-off had very little time to get back in. Experience shows that it is virtually impossible to pick the bottom of these sell offs. Once the market sells off, the same scaremongers will roll out their favorite cliché: Be careful, there is another leg down…

“The S&P 500 surged 8.2% over an eleven-day period in July, which reinforces the argument that the market does not wait on anybody. Its moves are irregular and more often than not, unpredictable, even to the so-called market experts. That being the case, time in the market, through the peaks and troughs is a dependable investment strategy that has withstood the test of time.

“Fact is, market timing is a fool’s errand and dangerous. What about this statistic: If you had missed the 90 best-performing days of the stock market from 1963 to 2004, your average annual return would have dropped from about 11% to a little more than 3%.”

With regard to the election outcome, we wrote:

“Regardless of who wins, the immediate reaction will be doom and gloom, perhaps accompanied by a sell-off and then normality will return as everyone realizes that the Executive Branch is but one of three branches of Government.

“When the dust settles, the Republicans may still hold the House and the Democrats may retake the Senate. Perhaps, the Republicans will land up holding everything. Unlikely, but we are not ruling that out. The polls were totally wrong in Britain earlier this year.

“A major dip in the market? Perhaps 10%, but it will be a distant memory three months later. We stick to our strategy. We hold the world’s best and highly profitable companies with resilient business models and, yes, when the markets sell-off, our stocks also trade down, but they recover very quickly once the panic selling stops.”


We do not know the future, neither do others. We have our doubts about tax reforms and, hence, remain cautious rather than give way to exuberance. It is tough to be a pessimist these days, and we certainly are not, and have never been of that mindset. Economic growth, though not robust, has picked up. The ISM manufacturing index hit a 13-year high in September. GDP growth drives earnings growth, negating fears about a market bubble in the making. Volatility, a major factor in the years following the recession, has taken a seriously long time-out. The S&P 500 has not experienced a 4% pullback since October 2016. Declines of 5% at a time occurred two to three times a year since 2009. Consumer and business sentiments are surging.

The yield curve, money supply, purchase mortgage applications, and the Chicago Fed Financial Conditions Indices are positive. Leading indicators, including industrial metals, the regional Fed new orders indexes, and staffing, all predict favorable economic conditions. Coincident indicators, including consumer spending, steel, tax withholding, the Baltic Dry Index and Harpex, are positive. The US economy is in good health and most other regions across the globe show a recovery mode.

The American Trucking Association has an index of total truck tonnage hauled by the nation’s truckers. If one superimposes the trucking index on a chart of the S&P 500, the correlation is striking, with some exceptions. There are times when the market suffers from “irrational exuberance,” or appears overly pessimistic. When this happens, it is clearly reflected on the two-chart comparison. Since 2012, the two charts have moved up in almost total harmony, with the S&P currently just a tad above the trucking index, but the line representing trucking activity is showing a sharp upward trajectory, a virtual convergence of the two charts. This suggests that the stock market is currently neither overly optimistic or pessimistic, more in synch with the economy.

The CoStar group published a chart that reflects growth in prices for commercial real estate, which currently runs above its 2007 peak and on a growth trajectory since 2009 very similar to what a chart of the S&P 500 shows. This might surprise some, seeing the media reminds us ever so often that shopping malls, strip malls and big box stores are a dying breed. If that were true, commercial property prices would be stagnant to declining.

Valuation multiples appear elevated, but interest rates are so low compared to prior periods, that equities remain the flavor of the day. A $30 stock with earnings of $1.50 trades at a P/E multiple of 20.0 ($30/$1.50). Some would regard this as expensive. Consider then a price of $63.50 and a P/E of 42.3 ($63.508/$1.50). Expressed as the inverse of P/E, namely, earnings divided by price, it comes to an earnings yield of 2.36% ($1.50/$63.50). A $100,000 10-year Treasury currently yields 2.36%, or a paltry $2,360 in interest income. Expressed in P/E terms, it comes to 42.3 ($100K/$2.360K).

These low rates show that capital seeking sovereign risk-free returns are not in short supply. Technology has allowed businesses to run with fewer capital requirements. WWI and WWII destroyed vast amounts of capital. Thankfully, subsequent wars have been regionalized and less destructive. This buildup of surplus capital translates into lower returns. We can add to this a dramatic decline in the rate of inflation. Equities are trading at valuation multiples that seemingly suggest a bubble compared to past periods. Shiller’s CAPE ratio seeks to normalize P/E ratios, but our current investment environment is unlike any seen in decades. Apparently, in Japan there is some talk of taxing retained earnings to incentivize corporations to invest more of their surplus capital.

According to a report published by Invesco on September 8, the NASDAQ 100 trades at a forward P/E ratio of 21.7. The 15-year average for this multiple is 20.1, placing the current trading range just 7.9% above the 15-year average.

The same report notes that the S&P 500 currently trades at a forward P/E of 18.8. The 15-year average forward P/E for the S&P is 15.4, which gives us a higher valuation premium of 22.2%.

Valuations alone will not prompt a major market correction. We need some catalyst, which brings us to our final thought.

North Korea

We are not qualified to speculate on these matters, but history might have a lesson for our political leaders on how to exercise restraint. North Korea’s Kim Jong-un and our very own Donald Trump seem to be unwilling to back down and temper the war rhetoric. Yet war is not an option, especially considering the intricate relationships between the warring parties and their allies. WWI started with the assassination of Archduke Franz Ferdinand, heir to the Austrian throne, in Sarajevo of all places. Instead of diplomacy, Austria-Hungary declared war on Serbia, and Russia, a Serbian ally, immediately mobilized its armed forces. Germany responded by warning France to remain neutral, in the event of a war between Germany and Russia. Historian George Kennan wrote that as if gripped by madness Europe’s political leaders gave up the continent’s relative wealth, stable political relations and cultural hegemony over large parts of the world and transformed the continent into a battlefield of unimagined proportions; all because of an incident which was insignificant in comparison to its consequences: “They were entranced by the prospect of what they stood to gain at the end of the war, and didn’t hear the foreboding voices warning them of their own demise.” May cooler heads prevail in Washington, otherwise the above will no longer be of any consequence.

Post Script: For those seeking valuable insights into our dysfunctional healthcare system, we recommend Harvard-educated physician, Elizabeth Rosenthal’s book, “An American Sickness: How Healthcare Became Big Business and How You Can Take It Back.”