President trump made the following crucial statement on February 9th: "We're
going to be announcing something I would say over the next 2 or 3 weeks that
will be phenomenal in terms of tax." To be sure, the nucleus of the President's
economic plan is the simplification of the tax code. To get this accomplished
means everything for the stock market. Without a reduction in tax rates the
air compressor that has been blowing up equity prices to near record and unsustainable
valuations will explode.
To be a successful investor requires the knowledge that there exists a strong
nexus between economics and politics. In just a few short weeks we will get
Trump's details on the tax plan. Understanding what form the tax plan takes
shape, or if there is any such plan enacted at all, is essential to your portfolio's
health because it will have a huge effect global currencies, bond prices, commodities
and equities.
Getting tax reform passed is going to be complicated and will involve the
following issues that need to be hashed out: border tax adjustments, trade
tariffs, repatriation of foreign earnings, limiting the deductibility of net
interest expense and eliminating other deductions, allowing companies to fully
expense, instead of depreciating capital expenditures, an infrastructure spending
package, and will the plan use dynamic or static scoring.
But the most important take away for investors is to determine which one of
the following 3 scenarios the final plan entails: will it be neutral to the
deficit, accretive to the deficit, or does the bill just die in the Senate.
The first outcome: Trump pushes through a simplification of the tax code that
is done in a revenue neutral fashion through the use of a border tax adjustment
or import tariffs. This may be a preferable course for Trump and the Republican
Congress to pursue because it can be accomplished through budget reconciliation,
which only requires a simple 51 vote majority in the Senate. In theory, this
would lead to a stronger dollar because our trade deficits would shrink. Bond
prices should fall (yields rise), but only moderately due to rising import
prices and a bit more growth resulting from tax simplification. Stock prices
should rise immediately after the passage of such reform but much of this has
already been priced into shares. Precious metals could suffer from the rising
dollar and the move into growth stocks. Finally, the Fed would remain on course
for 2-3 rate hikes during 2017.
The second scenario is that Trump gets his tax overhaul done with the help
of Democrats, which would require a 60 vote majority in the Senate. If the
proposed reduction in corporate and individual tax rates were to be accompanied
by infrastructure spending—especially the type that would be most amenable
to Senate Democrats—he may get it through; even though he will lose the most
fiscally conservative members. The major investment takeaway from this scenario
is that deficits would absolutely surge and that bond prices would crash. Equity
prices would most likely rise in the short-term because trading algorithms
are programed to love fiscal stimulus that is not offset by a reduction in
write-offs. However, stocks could run into a major sink hole once bond yields
soared past 3% on the Ten-year Note. The dollar's value should get hurt by
rising deficits but get a boost from the perceived rise in growth and the realized
rise in bond yields. Therefore, I find this scenario slightly dollar bullish.
Precious metals would benefit from rising debt and deficits but would at the
same time get hurt by rising long-term rates and the impetus of the Fed to
increase its planned 2-3 rate hikes to 3-4 hikes. Although this is the least
likely outcome it is still one that merits preparation.
The third possible outcome is that Trump's tax overhaul gets severely diluted,
or that it cannot get passed through Congress. The market will perceive the
paralysis in D.C. as extremely bearish for economic growth and that should
put the Fed on hold for the rest of 2017. The investment strategy for this
scenario is clear: Bond yields would crash along with the U.S. dollar. But
perhaps the most salient ramification for the inability to push through tax
reforms will be that equity prices plummet just as precious metals soar.
Why will stocks crash and gold skyrocket? Because the stock market rally is
predicated on the hype and hope provided by President Trump that the U.S. economy
can finally escape the anemic 2 percent GDP growth experienced over the past
eight years.
Just how extended have stock market valuations become riding this anticipation
of surging growth? According to famed investor John Hussman, the median price/revenue
ratio of individual S&P 500 component stocks now stands just over 2.45,
which is easily the highest level in history. The longer-term norm for the
S&P 500 price/revenue ratio is less than 1.0. Even a retreat to 1.3, which
we've observed at many points in recent cycles, would take the stock market
to nearly half of present levels.
Robert Shiller, the esteemed economist from Yale indicates that the S&P
500 now trades at 28x their trialing 10 year average earnings. This is the
same level as seen in 1929 and far higher than it was in 2007, just before
the Great Recession began. The average 10 year trailing earnings PE ratio is
just 16.7, which according to the professor's data would require a 60% haircut
in prices just to put the market back to historical norms. In addition, the
tailing 12 month PE ratio of the S&P 500 is at the 90th percentile; meaning
that 90% of the time observed over the past 80 years the PE ratio was lower
than it is today.
One last overvaluation metric to share. The total market cap to GDP ratio
now stands at 130 percent. The normal level is closer to 50 percent. The stock
market stands at a precipice virtually unparalleled in history that absolutely
requires radical growth measures to be adopted in order to keep the air flowing
into this bubble.
Investors have to pay close attention to both the economics and the politics
if you want to get your investment allocations correct. This has never been
truer than now.
