Q4 2016 Commentary: “Now it’s time to make money”

by Albert Meyer

Unlike this time last year, the mood among investors is bullish. Is this optimism misdirected? As ever, there is no shortage of pundits, hungry for media attention, stirring panic and angst. Nothing sells investment newsletters more swiftly than fear mongering.

On the other hand, energy sector earnings suffered in 2015 as crude oil prices plummeted to $30 a barrel, posting a 50% decline for the year. In addition, a stronger dollar negatively impacted the earnings of multinationals. In 2016, a rebound in oil prices has a given a boost to the S&P 500 earnings. This should continue into 2017.

Unemployment levels are low. The housing market continues to recover. Leading economic indicators reflect optimism. Investors, like us, are eagerly anticipating Donald Trump’s promise to cut the corporate tax rate to 15%.

Consider a company that earned net income of $750 million in 2015. If this company trades at a price-to-earnings (P/E) multiple of 20, it would have a market capitalization (market value) of $15 billion (20 times $750 million). At a tax rate of 35%, the company would have provided for taxes of approximately $404 million in 2015. All things being equal, if the tax rate drops to 15% in 2017, the company will report earnings of approximately $981 million (rounded), for a year-over-year increase of +31%. The market capitalization would also increase by +31% if the P/E multiple remains at 20. Stated differently, if the company had not paid any corporate taxes in 2015, its market value would have been higher by more than $8 billion (20 times the tax expense of $404 million). The government gets $404 million and shareholders lose $8 billion – only in Washington.

As noted above, a lower corporate tax rate will greatly enhance corporate earnings. As earnings growth drives stock prices, one can understand why some pundits are predicting a +20% gain in stock prices in 2017.

Another major event that could further strengthen a market rally is that US corporations have not repatriated the bulk of their foreign profits earned over the years in order to avoid our punitive 35% tax rate. At the end of 2015, 303 Fortune 500 companies collectively held $2.4 trillion offshore. Donald Trump has indicated that he wants this money back in the US. To this end, he will offer corporations a tax incentive. A few curmudgeons in the media superciliously argue that it would not benefit the economy because corporations would use the money to buy back their own stock. If corporations buy back $2 trillion worth of stock, the money will find its way into the pockets of the sellers of those stocks. Will these investors use the money to buy stocks, bonds, go on vacation, buy a new car or house, who knows? No matter what happens to the repatriated funds, it would definitely benefit the economy, and by implication, the stock market.

At the risk of getting too technical, we point out that a tax cut will also provide an enormous boost to the net book value (shareholder equity minus liabilities) of companies through a one-time gain following the restatement or downward adjustment of the deferred tax liability on the balance sheet. The tax code provides for the deferral of taxes for reasons that are too complicated to discuss. If a company defers taxes of, say, $100 million, it will have to provide for a deferred tax liability of $35 million ($100 million times the 35% tax rate). If the tax rate drops to 15%, the $35 million deferred tax liability would have to be adjusted downward to $15 million ($100 million times 15%). This adjustment would add $10 million to net book value and boost net income by $10 million in 2017. Think of it as a form of debt forgiveness.

Take Apple as an example. It has a deferred tax liability of $22 billion. As a rough approximation, this could lead to a downward adjustment of $12.5 billion at a tax rate of 15%. Apple has 5.336 billion shares outstanding, which means this adjustment would add $2.36 per share to net book value. As the company trades at a price-to-book value multiple of 4.85, all things being equal, it would add $11.45 to the stock price. As the stock currently trades at $116, the deferred tax liability restatement could boost the share price by close to +10%. It gets better. Apple’s deferred tax liability almost exclusively pertains to the deferral of taxes on un-repatriated foreign profits. If the tax code allows for the repatriation of these profits, a tax rate of, say, 5%, and not 15%, the liability would have to be written down to $3.1 billion, for a $18.8 billion boost to net book value and a potential +15% boost to the stock price. Apple’s bottom line stands to gain anything from $12.5 billion to $18.8 billion, which equals 27% to 41% of fiscal 2016’s net income.

Not only are the profits of these engines of economic growth and job creation taxed, but if they distributed their profits as dividends, a tax on dividends accrue to shareholders. To add insult to injury, when shareholders sell their stock, the IRS slaps a tax on the gain.

These are cold calculated facts, but in Washington, everything gets politicized, which is another way of saying that it will take a hardnosed approach from the new Administration to get the tax cuts past the know-nothings in Congress. Perhaps, Trump with his considerable business experience is just the person to put an end to the notion that taxing corporations is an efficient means of raising revenues. On the contrary, it destroys wealth and does inestimable harm to the economy. Most Americans have some exposure to the stock market, if through no other means than state and municipal pension funds, as well as private pension funds. The investments owned by these funds amount to trillions of dollars. Many of these funds are struggling to match their assets with their underlying pension benefit obligations. A corporate tax cut would most certainly relieve these funds of any pension deficits and place them on a much sounder financial footing.

A prominent Wall Street financier and ardent Democrat told a journalist, off the record, recently: “We lost. Now it’s time to make money.”

Pessimism Amidst a Renewed Sense of Optimism Prior to 2016, the S&P 500 averaged at least three market declines per year following the 2008/9 Great Recession. In 2016, we had a correction at the end of January, going into February. With the Brexit vote, the market sold off sharply, but after two days, the market snapped back. The S&P 500 rallied more than +8% in the second half after treading water for about 18 months. Even if the market gains the 20%-plus in 2017 as forecasted by many pundits, we expect a couple of corrections along the way, but don’t panic.

First Trust mutual fund managers, correctly in our view, argue that the “Plow Horse” metaphor aptly defines the US economy since 2009 – “an economy driven by new technology and entrepreneurship (fracking, the cloud, smartphones, big data…), but held back by the friction of a growing and burdensome government. Since mid-2009, real (inflation-adjusted) economic growth averaged a Plow Horse-like +2.1% per year. With the current forecast for Q4 real GDP at +2.5%, 2016 will finish right on that average.”

First Trust believes the old plow horse will get a spring in his step in 2017. They base this optimism on a number of factors: continued growth in the housing market, increased investment in new businesses and technology, less regulations, lower taxes, fewer government subsidies, further declines in the unemployment rate and a resurging energy sector. Not surprisingly, they project a +22% increase in the S&P 500 for the coming year to 2,700 with the Dow ending at 23,750.

While the celebrated investor and political activist, George Soros, anticipates a gloomy future for us all, billionaire hedge fund manager, Ray Dalio, is bursting out of his skin with optimism. He writes that, “It is increasingly obvious that we are about to experience a profound, president-led ideological shift that will have a big impact on both the US and the world… Trump is a deal maker who negotiates hard… and hell-bent on playing hardball to make big changes happen… This particular shift by the Trump administration could have a much bigger impact on the US economy than one would calculate on the basis of changes in tax and spending policies alone… It could spark a virtuous cycle in which people can make money, and the move out of cash (that pays them virtually nothing) to risk-on investments could be huge. Regarding attracting capital, Trump’s policies can also have a big impact because businessmen and investors move very quickly away from inhospitable environments to hospitable environments.” Dalio foresees a significant inflow of foreign capital to take advantage of what could become a more investor-friendly business environment.

On January 12, 2017, The Wall Street Journal reported that, “Billionaire hedge-fund manager George Soros lost nearly $1 billion as a result of the stock-market rally spurred by Donald Trump’s surprise presidential election… Many experts had predicted a tumble for stocks in the wake of the election, but instead the Dow Jones Industrial Average has climbed +9.3%. Last year, Mr. Soros returned to trading at Soros Fund Management LLC… Mr. Soros was lured back by the opportunities to profit from what he saw as coming economic troubles… Soros Fund Management gained about 5% on the year [2016]… the 86-year-old billionaire was a large contributor to the super PAC backing Democratic presidential nominee Hillary Clinton…”

Stanley Druckenmiller, Mr. Soros’s former deputy, according to the Journal, “anticipated the market’s recent climb and racked up sizable gains, according to people close to the matter… These trades have paid off as Mr. Druckenmiller’s firm, Duquesne Family Office LLC, scored gains of more than 10% in 2016… In October, Mr. Druckenmiller told Reuters that he backed Republican candidates for Congress in the hope of creating a ‘firewall’ against Mrs. Clinton’s likely economic policies, including more government control of health care.”

For a contrarian opinion, the major news networks are doing a great job warning us of the catastrophe awaiting us under the Trump Administration.

Professor Nouriel Roubini, CEO of Roubini Macro Associates, is one of the doomsayers that we will note here for future reference, as we have done in the past.

Roubini argues that Trump’s policies are similar to those pursued by the US in 1920s and 1930s, which lead to the Great Depression and World War II. He foresees (and blames Trump), the disintegration of Europe, the resurgence of pro-Russia movements in Europe, the further radicalization of militant Islam, exacerbation of tension in the Middle East, and a drastic shrinkage of international trade. The so-called “disintegration” of Europe was well underway, long before the Trump campaign made headlines. Russia is the Washington establishment’s new piñata. Government needs enemies, more imaginary than real, to justify a trillion dollar defense budget (including related expenditures allocated to departments others than defense). After all, “war is the health of the state.” (Randolph Bourne) Superimposing the 1920s and 1930s on the current economic landscape and drawing conclusions is disingenuous at best, but seriously flawed. However, time will tell.

For the record, in our Q2 2016 commentary, we wrote, “Nouriel Roubini warned that, ‘Brexit would cause significant damage to the UK economy and employment… the UK is much better off inside the EU… Brexit could stall the UK economy and tip it into a recession as the shock to business and consumer confidence could be severe.’”

In our Q2 2014 commentary, we pointed out that economists, such as Nouriel Roubini, predicted the bursting of the housing bubble long before the eventual blow up in 2008. Roubini first made his predictions in 2004. Consequently, he missed half of the great bull market 2003-2007, but convinced the media that he accurately predicted the implosion of 2008 and became a celebrity overnight. Since then he has regularly predicted an impending stock market crash, much to the chagrin of those who followed his advice failed to gain from the market’s relentless rise since 2009.

Former U.S. Treasury Secretary Lawrence Summers said investors are being far too sanguine about the risks associated with Donald Trump’s incoming administration. Summers dismissed the idea that any tax policy introduced to encourage US companies to repatriate profits would boost investment and hiring.

“The vast majority of the companies who have large overseas cash also have substantial amounts of domestic cash,” he told Bloomberg. “The reality is that cash that is brought home will be used to pay dividends, to buy back shares, to engage in mergers and acquisitions, to rearrange the financial chessboard, not to invest in large amounts of new capital. It is a chimera to suppose that there will be large increases in capital investment as a consequence of that repatriation.”

This reminds us of the Scotsman who asked a vicar if he would go to heaven if he gave the church a million pounds. To which the vicar replied, “It is an experiment well worth trying.” We would counter Summers’ skepticism with the same response. Bring the trillions home, and let’s see what happens.

We commented above on the inane notion that dividend distributions and stock buybacks do not benefit the economy. Since when are mergers and acquisitions detrimental to the economy? Putting all that cash, or even a fraction in the hands of the political elite, which is no doubt what Summers wants, is a truly horrendous idea.

It is clear that the political establishment (both parties), which has given us costly wars with disastrous consequences, huge deficits and unrestrained growth in the national debt, burdensome regulations, high taxes and lethargic economic growth, is not happy with the undermining of their cozy little fiefdoms. Dire consequences loom, in the face of unbridled optimism from other quarters. A very interesting four years, if not entirely painless, await us.

Market The three-day slide at year-end pushed the S&P 500 to its lowest level since December 6, but for the year, the index posted a more than satisfactory return of +9.5%. Our composite portfolio (all client portfolios combined) outperformed with a return of +11.43%, despite being on average 5% to 10% in cash over the last six months of the year. We were up +3.43% for the first seven trading days of the New Year, compared to the S&P 500’s +1.34% return.

We sold ARM Holdings and Linear Technology when both companies received buy-out offers. We sold MarketAxess after a +150% gain in less than three years and a P/E of 56 that offers no margin of safety should the company fail to meet Wall Street’s lofty expectations. MasterCard was served with a $19 billion class action lawsuit in the UK. We would normally ignore these tort-lawyer driven cases, as higher courts invariable grant substantial reductions in damages. However, as we have no familiarity with the legal system in the UK, we decided to sell. If the stock price declines to the $80-range, all things being equal, including the class action overhang, we will not hesitate to establish a new position. MasterCard is a standout company.

Here is an example of what happens to these class action lawsuits in the US. On January 3, 2017, US District Judge Ed Kinkeade halved the 1 billion damages award against Johnson & Johnson (JNJ). JNJ faced the possibility of a $1 billion payout to plaintiffs in six lawsuits for faulty hip implants. Judge Kinkeade reduced the award to $500 million. A federal jury handed down the initial award. Kinkeade cited “constitutional considerations” for reducing the sentence. JNJ will still appeal the court case.

Of the 25 worst performers in the S&P 500 in 2016, healthcare stocks occupied 11 spots. Last year, the healthcare sector was the worst performer among the ten sectors represented in the S&P 500. The last time this sector performed so poorly was in 2010. In 2011 and 2012, healthcare bounced back to being the third best performing sector and then the second best performer in 2013 and 2014. It was again the third best performer in 2015. We are confident that in 2017 healthcare will regain its reputation as a standout performer among its peers in the S&P 500. We are overweight healthcare/pharma, which makes our outperformance in 2016 more satisfying. We are also overweight financials, which helped negate some of the negative impact of healthcare/pharma.

As noted above, the year started well for us, until Donald Trump’s irresponsible comment that pharmaceutical companies are “getting away with murder” by charging high drug prices. Bloomberg noted that, “The healthcare sector dropped 0.787 percent after Trump said the country needs more competitive drug bidding.” The drug market is plenty competitive. It takes one to two billion dollars to discover and develop one of these “miracles cures,” as Bill Gates reminded us last year. Gates made this comment during a Bloomberg interview after Hilary Clinton’s took a similar jab at drug makers. On this front, apparently, nothing has changed since November 8.

Recall, the S&P 500 kicked off in 2016 by falling -8% over its first ten trading days, its worst first ten trading days in history. After its first 28 trading days, the index was down a little over -10%, again marking its worst start in history. What gave? China’s economy was apparently faltering. Oil prices were all over the place. The Fed just passed its first rate hike since June 2006. Predictions of an impending recession were rife. In retrospect, as always, this panic selling provided a great opportunity to invest in equities. As someone noted, “Volatility is not risk, it is the source of future returns.”

Even as fears about China subsided and oil prices stabilized, the worrywarts found a new sources of concern and reason to stay on the sidelines: the upcoming vote in Britain to exit the European Union. When that proved a damp squib, the results of the November election, regardless of the outcomes, were destined to send the market into a tailspin. We do not know what will or will not happen during the next 12 months, nor how the market would react.

On October 16, 2008, Warren Buffett wrote, in a New York Times op-ed. “I can’t predict the short-term movements of the stock market,” Buffett emphasized “I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

Jeffrey Saut, the chief investment strategist at brokerage firm, Raymond James, argues that a cut in the corporate tax rate to 15% “could prove to be difficult,” but even at a tax rate of 25%, the S&P 500 earnings estimate for 2017 would be approximately $144. A 17 P/E would give a price target for the S&P 500 of roughly 2,450 by the end of 2017 [$144 x 17 = 2,448], for a close to +10% increase. “In either event, we believe stocks are going to trade substantially higher over the next few years. Will there be pullbacks? You bet there will, but in our view pullbacks are for buying,” Saut writes.

Precarious Predictions After the S&P 500 returned -1.94% in October 2015, permabear Jeffrey Gundlach predicted another -5% or -10% drop for the index. Gundlach, told CNBC in the beginning of November 2016 that, “The dam is breaking, you can feel it.” The market headed in the opposite direction, taking out new highs along the way. He repeated this call on January 11, 2016. He is going to get it right eventually.

James Juliano of the “Reading the World” blog took a contrarian view and predicted a +30% surge within a year in the event of a Trump presidency. Juliano saw Trump as the only candidate with a “pro-growth economic policy agenda,” and pro-growth ideas. Juliano also thinks the S&P 500 will double in as soon as three years. If the S&P 500 index reaches 4,400 by 2019, as Juliano predicts, it would post a return of +9.0% p.a. over the past 30 years, which is in line with the long-term average of the index. We have noted in the past that 1990 is a good point from which to measure long-term return on the index. Over the past 30 years, China liberalized its economic policies, the Soviet Union collapsed, technology made huge strides in the way we communicate and trade globally. In addition, changes in the accounting rules over the past three decades make it increasingly irrelevant to compare earnings-based valuations prior to 1990 with those of today.

“When the reality of no stimulus catches up with the perception of stimulus, plus the Fed tightening, that’s the train wreck. Either we’re going to have a recession or a stock market correction,” Jim Rickards, editor of financial newsletter Strategic Intelligence told CNBC in a post-Christmas interview. Notice, Rickards sells a financial newsletter.

The market-timers tell us, incessantly, that the market is now at about the same level that is was before the crash of 1929, or during the ill-fated boom of the late 1960s, or any other date that looks mildly appropriate.

Some diehards still base their calls for a market correction on Robert Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio. The good old CAPE metric, devised by Nobel Laureate Robert Shiller, compares stock prices to earnings of the past 10 years, rather than just one year, hence the acronym CAPE. By CAPE’s measure, stocks have been overvalued since the mid-1990s. A new research paper by two economists, Valentin Dimitrov at Rutgers and Prem Jain at Georgetown (“Shiller’s PE: Market-Timing And Risk”) contend that the problem with CAPE lies with the over-simplistic way in which investors have applied it. It is a bit late in the day to tell investors this but, according to the authors, one should not have placed cash on the sidelines when the Shiller P/E was above average, no, not even when it was way above average. Investors should only sell their stocks when the Shiller P/E reaches extreme levels. Apparently, now is the time.

The problem is that comparing earnings report in 1950 with earnings reported in 2016 is like comparing apples to oranges. Through the years, the accounting rules have changed (hopefully for the better), which means a P/E (price-to-earnings ratio) of 20, say, fifteen years ago was based on earnings substantially different from the earnings used today to calculate a P/E ratio for the S&P 500. A substantial reduction in the corporate tax rate will make 2017’s earnings incomparable to last year’s numbers and more so with prior years. At a 15% corporate tax rate, CAPE ratios based on historic earnings will become meaningless.

Back in September 2014, when the S&P 500 crossed 2,000 for the first time (August 25, 2014, to be exact), Nick Summers at Bloomberg’s BusinessWeek, dismissed Professor Shiller’s August 16, 2014, warning. Shiller contended that his influential Shiller P/E ratio has reached a “worrisome level,” one not seen since 1929, 1999 and 2007 – “years that are synonymous with bursting bubbles.” The article wisely quoted Peter Lynch, of Fidelity Investment fame, who said that, “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in correction themselves.”

Summers reiterated our longstanding argument that rallies tend to follow crashes. “It’s that getting caught in an especially bad downturn – the thing that so many investors worry about – really isn’t so bad if you’re in the game for the long-term.” At the time, September 7, 2014, Summers reminded his readers that, “the S&P 500 has lost more than 5% in a calendar month 33 times during the past 30 years. But buy-and-hold advocates have long pointed out the risk of missing rallies while trying to avoid drops… investors who missed out on the market’s 10 best days over the last 15 years would have had annualized gains of only +2.1% compared to the almost 6.5% for a portfolio that stayed fully invested. That’s the difference of $11, 911 for a starting stake of $10,000.”

Hedge Funds On December 30, 2016, Bloomberg reported that capital “allocators are increasingly turning away from hedge funds as their returns have trailed stock markets.” The article cites hedge fund manager, David Einhorn, who looked like a genius in 2009. He happened to be short the housing and financial sector. Since then, his fund, Greenlight Capital, has not lived up to expectations, especially not in 2015 when it lost -20%. In 2016, according to Bloomberg, the fund’s performance almost matched the S&P 500 with a return of +9.4%. Here is the problem for investors when they lose -20% in Year 1 and only gain +9.4% in Year 2. To recoup Year 1’s losses, investors need a +25% return in Year 2. Having fallen short of this target in 2016, Einhorn’s investors would now need another +14.3% return on their capital to break even with what they had invested at the beginning of 2015. Assume they earn a highly respectable +20% in 2017. That would only give them a +1.65% p.a. return over the past three years (2015 to 2017). There is some tough sledding in store for the folks at Greenlight Capital.

Oxford educated and London-based hedge fund manager, Crispin Odey, who had $7 billion under management in 2011, reportedly posted losses of almost -30% for the year (as of July 29, 2016). He then went for the Hail Mary pass by increasing his fund’s gold exposure to 86%. On November 3, 2016, Bloomberg reported that, “Assets under management at Crispin Odey’s flagship hedge fund have plunged 60 percent this year after clients demanded their money back as his bearish bets fell apart in the wake of central-bank interventions and near-zero interest rates. The Odey European Inc. fund held 422 million euros ($468 million) at the end of September, down from 1.1 billion euros at the start of the year… The fund lost -37.5% during the period and -43% through Oct. 14.” “Bull markets do not die of old age. They are murdered by central banks.” Odey wrote to investors in his February 2016 newsletter.

We absolutely follow the logic of those who bash central banks, but too many of them have allowed their anti-Fed emotions to interfere with their stock-picking prowess. They got the theory right, but in practice, they made the wrong trades. John Maynard Keynes was right when he warned that, “The market can stay irrational longer than you can stay solvent.” This sage advice pertains particularly to those who take short positions based on their assessment of the Fed’s “irresponsible” behavior.

In this context, Steve Forbes (editor-in-chief at Forbes), wrote back in February 2016: “To see why the outlook for the global economy gets gloomier, just look at what John C. Williams, president of the Federal Reserve Bank of San Francisco, said at a press conference… His answer encapsulates the fatuousness of the central bank thinking that has wrought immense destruction on the global economy. When asked how a 2% rise in the cost of living – which would add an additional $1,000 in expenses annually for the average American family – would boost the economy, Williams, with the insouciance of the obliviously ignorant, responded that the inflation would lead to a 3.5% rise in real wages. In other words, $1,000 in extra expenses would trigger a rise in a family’s income of almost $3,000. If only!”

Market Strategists Last December, market strategists polled by Bloomberg predicted a gain of +9.5% for the S&P 500, the accuracy of which is unprecedented going back to 2000. Their mean estimate for the S&P 500 was 2,216, just short of the actual close of 2,238.83. Since 2000, the average gain foreseen by forecasters surveyed by Bloomberg has been +9.3%. By sticking close to their average estimate, they nailed it in 2016. However, by mid-year, they lowered their estimated gain in the S&P 500 to +3.2%. The sharp sell-off earlier in the year and the Brexit vote spooked them.

Surprisingly, these strategists estimate that for 2017 the S&P 500 will on average only gain +5.2%, with the top-to-bottom spread in forecasts at its narrowest in a decade. At the same time, they predict a +12% rise in Y/Y earnings for the S&P 500 companies. In other words, to justify their subdued outlook for the index, they assume some a retreat in the market’s P/E multiple from the current 20.9 toward historical averages in the 17.0-range. They also do not want to factor in a Trump tax cut, perhaps because their bosses were big contributors to the Clinton campaign. We don’t care who delivers the tax cuts. It is not a political issue for us. Just do it.

The current forecast of earnings and revenue growth of +11.5% and +5.9%, respectively, for the S&P 500 is the best since 2013. Wall Street analysts (not strategists) expect earnings growth of +14% for the Dow Jones Industrial Average.

Since November 4th, the value of the US stock market has increased by just over $2 trillion, according to Bloomberg – most probably in anticipation of the Trump tax cuts, but only once the cuts become a reality will be able to judge whether the market’s upsurge was justified or not. In addition, the expected real growth rate of the US economy has increased by roughly +0.5% per year, which translates into an additional $1 trillion per year in national income. Likewise, the global purchasing power of US residents has increased by about +6% according to the foreign exchange markets. The price of gold declined over -13%, which indicates an easing in the general anxiety level.

Consumer confidence is running high, which always calls for some reflection. Again, only once we know the outcome of the proposed tax cuts can we tell if this confidence is misguided or not.

According to AAII’s weekly survey of individual investors for the last week of the year, bullish sentiment declined from 44.66% down to 44.61%, which represents the 103rd straight week where bulls have not been in the majority. At the same time, the percentage of pessimists dropped from 32.33% down to 29.15%.

The Dow The DJIA (Dow) is about 50 points away from crossing the 20,000 threshold. It took the DJIA close to two years to increase from 18,000 to 19,000. It did so on November 22, 2016. If it does cross 20,000 by the end of January 2017, it would have achieved this +5.2% move in 87 days.

The +7.14% move from 14,000 on June 19, 2007 to 15,000 on May 7, 2013, took 2,119 days (5.8 years). It took even longer, 2,726 days (7.5 years), to cross over from 11,000 (May 3, 1998) to 12,000 (October 19, 2006), a +9.1% move.

If one takes the price targets of analysts for the 30 Dow stocks, the Dow would increase by +4.6% (913 points) if all these targets are met simultaneously. Price targets on United Health and Apple of +13.3% and +13.5% respectively, would add 250 points to the Dow, but Nike’s +20% price target would only add 70 points because if its relative low share price. Analysts are bearish on eight DJIA stocks. Price targets on IBM and Goldman Sachs project declines of -5% and -2%, respectively.

Recession Watch We have noted in the past that the Yield Curve has been a good predictor of recessions. Currently, according to the experts who track this indicator, it shows a 3.74% probability of a recession in the United States within the next twelve months. The Marcelle Chauvet and Jeremy Piger model relies on 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, last updated on January 3, 2017, currently shows a 0.46% probability using data through October 2016. The Wall Street Journal’s December 2016 Economic Forecast Survey among economists places on average a 16.79% chance of a recession in 2017.

Interest Rates Last December 2015, Janet Yellen indicated that we could see a couple of interest rate increases in 2016. For various reason these hikes never happened, other than the one recently announced, but, again, accompanied by the promise of more to come. This time round it does not take a mastermind to predict that higher rates are on their way. The unemployment rate now hovers around 4.6%. The weekly jobless claims have kept below 300,000 for the 95th straight week, the longest stretch since 1970. Consumer confidence is soaring. Trump’s promised tax cuts will be the perfect antidote to a stock market running scared in the face of interest rate hikes.

United Kingdom The worrywarts and prophets of doom had nothing good to say when UK voters chose freedom over the shackles of Brussels. The temerity of the subject class to thumb their noses at the ruling elite, was nothing short of earth shattering.

Investors in UK equities had no such qualms, and for that, they realized huge returns. The FTSE 100 index gained +14.4% in 2016, its biggest advance since 2013, and easily enough to put the London benchmark ahead of its European peers, with the Stoxx Europe 600 index down -1.3% for the year and Germany’s DAX 30 index + 6.7% higher. The -17% decline in the pound helped the FTSE because a high proportion of FTSE 100 earnings come from outside the UK. However, while the media focused on a weaker pound to castigate the Brexit voters, the Euro is down – 14% for the year, hardly a vote of confidence from the currency markets.

Economic Indicators A review of economic indicators paint an optimistic picture of the US economy. The comparisons below relate to the month of November, unless otherwise specified. Year-over-year (Y/Y) the indices that measure durable manufacturing, capacity utilization and overall manufacturing were down about -2%, but the manufacturing ISM Manufacturing Report – see below – points to a positive outlook among manufacturers. Personal Income was up +4.03% Y/Y. New home sales units increased +16.54% Y/Y. Retail store sales grew +3.75% Y/Y. The value of building contracts increased +12.22% Y/Y from $568.8 billion to $638.3 billion. Construction spending grew +4.10% Y/Y, from $1.135 trillion to $1.182 trillion. Domestic crude oil production in December increased +6.22% Y/Y. The Purchasing Management Index (PMI) at the end of December ramped from 48.0 a year ago to the current level of 54.7. In the third quarter, exports grew +1.96% Y/Y ($2.120 trillion to $2.162 trillion), while imports only show a +0.63% increase ($2.668 trillion to 2.684 trillion). Export orders were unusually strong in December. This indicates an improvement in the economies of our trading partners, even in the face of a stronger dollar. The manufacturing indices of the Eurozone are also pointing to a strengthening of economic conditions abroad. The Case-Shiller Home Price Index rose by +4.26% Y/Y in October. A notable negative relates to new housing permits and new housing starts that declined -6% in December, but homebuilders remain optimistic – see below. At the end of November, the index of leading indicators was up +0.56% from a year ago and the index of lagging indicators up +2.92%. For the month of December, steel production was up +10.56%. The industry’s rated capacity grew +11.46% Y/Y. Also for the month of December, auto sales, including trucks, for both domestic and imported units, were up +3.09% Y/Y.

Employment Jobless claims of 265,000 at the end of the year marked the 95th straight weeks of sub-300,000 numbers, which is the longest streak since 1970. On a non-seasonally adjusted (NSA) basis, jobless claims increased from 315,100 up to 340,000, which was more than 130,000 below the average since 2000 and the lowest reading for the current week of the year since 1970.

The US labor market ended 2016 with a yearly gain of more than 2 million jobs for a sixth year in a row. The streak of gains above 2 million is the longest since 1999, when Bill Clinton was president.

The 156,000 increase in December payrolls followed a 204,000 rise in November that was bigger than previously estimated, according to the Labor Department. The jobless rate ticked up to 4.7% and wages rose +2.9% from December 2015. The labor participation rate, which shows the share of working-age people in the labor force, increased to 62.7%, from 62.6%. This relatively low number is a function of the rate of retirement among baby boomers, a sizeable increase in the number of workers now receiving disability benefits, below average economic growth since the Great Recession and the additional burden that healthcare insurance and minimum wage increases have placed on employers. It also means that as wages continue to rise in a tight labor market, millions of workers, not currently seeking work or part-time positions, could come to the market, which in turn, will have a dampening effect on wage increases.

Private employment, which excludes government agencies, rose by 144,000 in December 2016 after a 198,000 increase the prior month. Government employment rose by 12,000. Factory payrolls gained by 17,000, after a 7,000 decline in the previous month.

Manufacturing The ISM Manufacturing Report for the month of December was better than anticipated. Economists were expecting a headline reading of 53.8, but the actual reading came in notably higher at 54.7, which was the highest level in exactly two years. This number indicates fourth quarter GDP growth in the +3% to +4%-range. Accordingly, the Atlanta Fed’s GDPNow forecast for the fourth quarter was raised to +2.9% from +2.5%.

The internals components were also mostly to the upside. On a month/month basis, just two components declined, while on a year/year basis only one component declined. The biggest gainers this month were Prices Paid, New Orders, and Production. In the case of Prices Paid, that index rose 11 points to 65.5, which was the highest monthly reading since June 2011. The ISM manufacturing index offers a useful representation of strength in the broader economy.

Non-Manufacturing The ISM Non-Manufacturing report for December also surpassed expectations, coming in at a level of 57.2 versus consensus expectations for 56.8.

The strongest component in December was New Orders, which jumped to the highest level since August 2015.

Consumer Confidence Consumer confidence climbed in December to the highest level since August 2001, according to a report Tuesday from the New York-based Conference Board. A measure of consumer expectations for the next six months rose to 105.5, the highest since December 2003, from 94.4.

American households are expecting a Donald Trump administration to deliver. They are more upbeat about the prospects for the economy, labor market and their incomes, according to the Conference Board’s report. The results corroborate surveys by the University of Michigan and the National Federation of Independent Business, which showed jumps in household and business sentiment on Trump’s pledges to boost jobs, cut taxes and ease regulations.

Auto Sales Ford’s F-Series trucks offer anecdotal evidence of a healthy auto market. Total sales of F-Series trucks in December came in at 87,500, the best month of December for Ford F-Series sales since 2005 and the third best December in the last 20 years. For 2016, total sales of F-Series trucks were just below 812,000, also the best year for total sales since 2005. Improved sentiment is also reflected in the fact that sales of F-Series trucks in the last two months of the year, post-election day, amounted to 159,600. The only other year where the last two months of the year saw a higher sales total was in 1996, namely, 161,900.

The provisional estimate of auto sales for 2016 is 81.230 million, which beats the revised consensus estimate of seasonally adjusted annual rate (SAAR) sales of 17.7 million set in November 2016. The SAAR reported in November 2015 was the previous high-water mark for the industry.

Homebuilders Economists track the mood among homebuilders by way of a sentiment index. At the end of November, these economists were expecting a reading on the index of 63, unchanged from November’s reading. Were they ever wrong? The actual reading of 70 was off the proverbial charts. This was the highest reading since July 2005. We have not seen such a large diversion from expectations since 2003. Optimism among homebuilders is at a 10-year high.

Fed Surveys By mid-December 2016, two Fed surveys out of the New York and Philadelphia regions showed impressive strength. In the New York region, the General Business Conditions of the Empire Manufacturing report came in at a level of 9.0 versus expectations for a level of 4.0. This was the highest level since April’s 9.6 and the second-highest reading since January 2015. The index that measures expectations for six months from now rose from 29.9 to an impressive 50.2, the highest the highest reading since January 2012 and the largest one-month increase since November 2011.

In the Philadelphia region, the headline index for business conditions massively exceeded consensus expectations of 9.1, rising from 7.6 up to 21.5. This is the highest monthly reading and the largest one-month increase since November 2014. These are sentiment indices, not based on hard data, but as such, it reflects a huge change in business sentiment.

Small Business Small business optimism also surged in November, posting its largest month-over-month gain in more than three years. The overall index of small business optimism rose from 94.9 up to 98, the highest monthly reading since December 2014, but still below its cycle peak of 100.3. Expectations are high for pro-growth economic policies after eight years of taxes and regulations that have depressed growth to a level that merely matched population growth.

Conclusion It has been a long time since we have started a new year in the absence of an overriding sense of pessimism. Yes, the prophets of doom are still trying to stir the pot, but with a decent year behind us, despite the dire prediction of many, it has taken the wind out of their sails. Our optimism stems from the prospects of a major cut in the corporate tax rate. We are guarded in our enthusiasm, because logic and common sense are in short supply in Washington.

One rebuttal concerns the impact of a major tax cut on the budget deficit. We have argued before that transferring capital from the engines of growth to bureaucrats in Washington is a negative for the economy as a whole. Any steps to reduce this flow of capital will produce growth and hence additional tax revenues from other sources. However, we favor sensible and sizeable reductions in government spending to counter any potential revenue shortfalls in the short-term from a cut in the corporate tax rate. Writing in Barron’s, J.E. Dreier, argues for spending cuts of $100 million through the elimination of the Education Department ($69 billion) and farm subsidies ($29 billion). That will compensate for about a third of the taxes raised from corporations. Each state has its own Department of Education. There is no need for duplication at the federal level, which is why our founding fathers made no provision in the Constitution for such boondoggles. Dreier also notes that another $200 billion could be raised if the federal, state and local retirement age is raised to 67, as well as including all government workers in Social Security so that these workers would pay 13.5% of annual earnings to the Treasury. Our preference is to give young people a choice to opt out of Social Security, provided they place similar funds with private insurers. If Social Security is such a great idea, nobody would opt out. Right?

Another major defect in Washington that could turn a promising year ahead for the stock market into a nightmare concerns the hawkish rhetoric on the Hill. We are currently at war, or engaged in hostile acts, with five nations (Yemen, Syria, Iraq, Afghanistan, Libya) and spoiling for major confrontations with Russia, Iran, North Korea and China (its small islands in the China South Sea, apparently threaten our national security). Beating swords into ploughshares, and trading with all and sundry would be so much more sensible for all countries concerned.

As we finish this commentary, one newspaper headline reads: “READY FOR WAR US Army moves 2,500 tanks, trucks and military vehicles into Europe in the biggest troop transfer since the Cold War.” Our foreign policy can be summarized in two words: regime change. The Putin regime, sitting on vast oil resources, is too independently minded to Washington’s liking; similar to the recently deposed leaders of oil producing nations Libya, Iraq and still-in-progress Iran and Syria. Washington wants a puppet regime in Russia with the view of unrestricted access to its oil on favorable terms. The seeds of war are being sown, hoping Putin will back off, or preferably, the Russian nation votes him out of power. To date, Putin bashing has merely increased his popularity.

In short, we look forward to 2017 with unusual optimism. Trump’s attitude towards Russia and Putin differs starkly from that of the old establishment. He has also promised major reforms that promise huge benefits for the economy as a whole and corporations in particular. On the downside, his appreciation of the benefits of international trade seems lacking. Hopefully, the brain trust he has gathered will separate his actions from his rhetoric.

Regardless, we stick to our strategy. We hold the world’s best 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.


“Now it’s time to make money.”

by Albert Meyer

Unlike this time last year, the mood among investors is bullish. Is this optimism misdirected? As ever, there is no shortage of pundits trying to stir panic and angst to gain media attention. Nothing sells investment newsletters more swiftly than fear mongering.

On the other hand, consider the fact that energy sector earnings suffered in 2015 as crude oil prices plummeted to $30 a barrel, posting a 50% decline for the year. In addition, a stronger dollar negatively impacted the earnings of multinationals. In 2016, a rebound in oil prices has a given a boost to the S&P 500 earnings, and this should continue into 2017.

Unemployment levels are low. The housing market continues to recover. Leading economic indicators also reflect optimism. Investors are stoked over Donald Trump’s promise to cut the corporate tax rate to 15%. We wrote about this last month.

Consider a company that earned net income of $750 million in 2015. If this company trades at a price-to-earnings (P/E) multiple of 20, it would have a market capitalization (market value) of $15 billion (20 times $750 million). At a tax rate of 35%, the company would have provided for taxes of approximately $404 million in 2015. All things being equal, if the tax rate drops to 15% in 2017, the company will report earnings of approximately $981 million (rounded), for a year-over-year increase of +31%. The market capitalization would also increase by +31%, if the P/E multiple remains at 20. Stated differently, if the company had not paid any corporate taxes in 2015, its market value would have been higher by more than $8 billion (20 times the tax expense of $404 million). The government gets $404 million and shareholders lose $8 billion – only in Washington.

As noted above, a lower corporate tax rate will greatly enhance corporate earnings. As earnings growth drives stock prices, one can understand why so many pundits are predicting a +20% gain in stock prices in 2017.

Another major event that could provide further strength to a market rally is that US corporations have not repatriated the bulk of their foreign profits earned over the years in order to avoid our punitive 35% tax rate. At the end of 2015, 303 Fortune 500 companies collectively held $2.4 trillion offshore. Donald Trump has indicated that he wants this money back in the US. To this end, he will offer corporations a tax incentive. A few curmudgeons in the media superciliously argue that it would not benefit the economy because corporations would use the money to buy back their own stock. If corporations buy back $2 trillion worth of stock, the money will find its way into the pockets of the sellers of those stocks. Will these investors use to the money to buy stocks, bonds, go on vacation, buy a new car or house, who knows? No matter what happens to the repatriated funds, it would definitely benefit the economy, and by implication, the stock market.

At the risk of getting too technical, we need to point out that a tax cut will also provide an enormous boost to a company’s net book value (shareholder equity minus liabilities) through a one-time gain following the restatement or downward adjustment of the deferred tax liability on the balance sheet. The tax code provides for the deferral of taxes for reasons that are too complicated to discuss. If a company defers taxes of, say, $100 million, it will have to provide for a deferred tax liability of $35 million ($100 million times the 35% tax rate). If the tax rate drops to 15%, the $35 million deferred tax liability would have to be adjusted downward to $15 million ($100 million times 15%). This adjustment would add $10 million to net book value and boost net income by $10 million in 2017. Think of it as a form of debt forgiveness.

Take Apple as an example. It has a deferred tax liability of $22 billion. As a rough approximation, this could lead to a downward adjustment of $12.5 billion at a tax rate of 15%. Apple has 5.336 billion shares outstanding, which means this adjustment would add $2.36 per share to net book value. As the company trades at a price-to-book value multiple of 4.85, all things being equal, it would add $11.45 to the stock price. As the stock currently trades at $116, the deferred tax liability restatement could boost the share price by close to +10%. It gets better. Apple’s deferred tax liability almost exclusively pertains to the deferral of taxes on un-repatriated foreign profits. If the tax code allows for the repatriation of these profits a tax rate of, say, 5%, and not 15%, the liability would have to be written down to $3.1 billion, for a $18.8 billion boost to net book value and a potential +15% boost to the stock price. Apple’s bottom line stands to gain anything from $12.5 billion to $18.8 billion, which equals 27% to 41% of fiscal 2016’s net income.

Not only are the profits of these engines of economic growth and job creation taxed, but if they distribute their profits as dividends, a tax on dividends accrue to shareholders. To add insult to injury, when shareholders sell their stock, the IRS slaps a tax on the gain.

These are cold calculated facts, but in Washington, everything gets politicized, which is another way of saying that it will take a hardnosed approach from the new Administration to get the tax cuts past the know-nothings in Congress. Perhaps, Trump with his considerable business experience is just the person to put an end to the notion that taxing corporations is an efficient means of raising revenues. On the contrary, it destroys wealth and does inestimable harm to the economy. Most Americans have some exposure to the stock market, if through no other means than state and municipal pension funds, as well as private pension funds. The investments owned by these funds amount to trillions of dollars. Many of these funds are struggling to match their assets with their underlying pension benefit obligations. A corporate tax cut would most certainly relieve these funds of any pension deficits and place them on a much sounder financial footing.

A prominent Wall Street financier and ardent Democrat told a journalist, off the record, recently: “We lost. Now it’s time to make money.”