Morning Briefing Archive (2018)
Autonomous Auto World
January 18, 2018 (Thursday)
Technology: Driving Change. Last week, the Consumer Electronics Show (CES) produced lots of news about technology, some of which centered on automobiles. This week, Detroit is hosting the North American International Auto Show, where there’s tons of news about the latest automobiles, some of which centers on technology. The auto industry finds itself balancing the need to show new cars and trucks that will grace showrooms this year with its focus on electric and autonomous vehicles that may drive the industry’s future. I asked Jackie to have a closer look. Here’s what’s in store for the industry both today and tomorrow:
(1) Spiking sales. The auto industry wrapped up 2017 in much better shape than expected. Sales in the fall spiked as consumers replaced cars ruined by the rough hurricane season. December motor vehicle sales totaled 17.9 million units (saar), following November’s 17.5mu pace (Fig. 1). The spike reversed the industry’s sales slump that started in January 2017 and lasted through August, when sales fell to a low of 16.1mu (saar).
Before hurricanes destroyed cars this fall, the sales slump was expected to continue as new auto sales were to face tough competition from cars for sale after coming off three-year leases. The average price gap between new cars and three-year-old leased cars widened to $14,200 last year, up from $10,500 in 2010, the 1/8 WSJ reported. The gap is expected to widen further as 12% more vehicles come off lease in 2018 than did in 2017.
Now the question is whether auto sales will hold onto their post-hurricane gains or whether they will return to their sluggish summer ways. On Tuesday, GM sounded a positive note. The company expects 2017 earnings per share at the high end of its $6.00-$6.50 forecast. That’s up from company guidance in October that EPS would come in in the middle of the range, implying GM had a stronger Q4 than expected. The auto company also forecasted results this year would be “largely in line with expected 2017 results.” The forecast is far more optimistic than analysts’ estimates for 2017 earnings of $6.29 a share and 2018 EPS of $5.19.
Ford’s forecast for this year isn’t as optimistic. The company expects operating earnings to fall to $1.45-$1.70 a share this year, down from the $1.78 it estimates it earned in 2017. Ford blamed the decline on higher commodity costs and adverse exchange rates, and plans to reduce the number of passenger cars it sells while increasing the number of more-profitable SUVs and trucks it offers. The low end of Ford’s 2018 forecast, delivered Tuesday night, is below the $1.59 a share analysts were targeting.
The S&P 500 Automobile Manufacturers stock index (GM and F) fell in the first half of 2017 and rallied in the back half, reflecting the industry’s Q4 sales spike. For the year, the index rose 10.6%, almost half the S&P 500’s 19.4% gain (Fig. 2). Expectations are quite low for the manufacturers, with revenue expected to fall 0.8% y/y over the next 12 months and earnings forecasted to drop 7.4% over the same period (Fig. 3). At 7.6, the industry’s forward P/E multiple is in the middle of the 5.0-10.0 range it has kept within since 2010 (Fig. 4).
(2) Looking ahead. Despite uncertainty about sales over the next 12 months, there are many exciting developments in the auto industry, including the advent of electric and autonomous vehicles. GM, Alphabet’s unit Waymo, and Aptiv (formerly “Delphi Automotive”) appear to be in the lead when it comes to developing driverless cars.
Waymo has had autonomous cars in Phoenix driving volunteers who sit behind the wheel but don’t steer. In October, its autonomous minivans started driving around with employees in the back seat and no one behind the wheel. Up soon: putting volunteers in the back seat of the autonomous minivans, with no one behind the wheel.
“Part of what we’ve been trying to do with our technology is make it completely autonomous and not reliant on any new or incremental infrastructure or infrastructure change,” explained Waymo’s CEO John Krafcik at the LA Auto show in November.
GM, which has been testing autonomous vehicles in San Francisco, has applied to the National Highway Traffic Safety Administration for permission to deploy a car without a steering wheel or pedals by next year. The company argues that its driverless cars have encountered more challenges than others’ driverless cars because GM is testing the cars in San Francisco’s tougher driving environment, reported a 1/12 article in The Verge.
At the CES, Lyft was offering rides to attendees in cars that use Aptiv’s autonomous driving system. There was still someone in the front seat monitoring the car’s progress. But Aptiv’s CEO Kevin Clark said autonomous cars would be available this year, according to a 12/4 Bloomberg article.
Clark predicted the expense of self-driving software and equipment would mean the first autonomous vehicles would be used by delivery vehicles and robot taxis, looking to eliminate the cost of drivers. Clark didn’t see a market for individual users of autonomous cars developing until 2025, when he predicts the cost will have declined to $5,000 from today’s $80,000 to $150,000 price tag.
(3) Smarter cities. Ford’s autonomous offering will be available for commercial operation in 2021. Ford CEO Jim Hackett’s presentation at CES focused on autonomous cars in smart cities. Hackett and his team explained how sensors in cars, buses, trains, signs, bikes, traffic signals, etc. all would communicate to improve life in cities.
In such an environment, traffic signals can be changed to keep traffic flowing and reduce congestion and pollution. Traffic can be routed around sporting events or the way can be cleared so emergency vehicles can arrive at their destination faster. Drivers can see where there are parking spots, eliminating the need to endlessly circle until a spot frees up.
Ford believes smart cities will have fewer parked cars and more trees and benches. It envisions a world where an unmanned vehicle could pick up packages from two different small businesses and deliver those items to two different places, doing so at lower cost and more efficiently than can be done today. In smart cities, ridesharing becomes easier and commuters can switch easily between different forms of transportation and arrive at work more quickly.
(4) A contrarian view. The great thing about this developing world is that no one quite knows how it will all play out. Eran Shir is the founder of Nexar, a company that makes car dashcams that film rides and collect information. His blog posts turn many of the assumptions about the autonomous vehicle’s impact on the city on their head. Most assume cities will continue the recent trend of getting more congested. Shir questions whether cities might empty out as autonomous vehicles make longer commutes more productive and enjoyable, allowing people to live further from city centers.
The number of grocery stores and post offices in cities might decline if companies like Amazon develop what are essentially vending machines on wheels, storing and delivering frequently requested items, Shir speculates. If commuters take their autonomous car into the city, might they opt not to park it but rather let it drive the city streets, earning money by picking up passengers while owners are at work? If many people “rent” out their cars during the work day, will there still be a need for Uber, Lyft, or taxies? If everyone’s cars are circling town, Shir wonders, might city streets get more congested rather than less so, perhaps leading to road usage charges?
Will truck-stop towns and rest stops dwindle in number if autonomous long-haul trucks come into existence? Will people stop taking short commuter flights between cities, Shir questions, opting instead to hop in an autonomous car? Along those lines: If RVs and cars pulling Airstream trailers become autonomous, might communities of roving retirees riding around in their homes replace Florida retirement communities as the norm?
If all this talk of the future makes you a little queasy, have no fear: You’ll have a few more years before these issues come to the fore. None of the hot-shot new autonomous vehicles won the car of the year at the Detroit Auto Show. The winner: Honda’s Accord.
Valuation: Beauty & the Beast
January 17, 2018 (Wednesday)
Valuation: Extremely Fair. Despite the extraordinary ascent in their prices, stocks aren’t extremely overvalued. Of course, by some measures, they are as overvalued as they were at the tail end of the tech bubble during 1999 and early 2000. As Joe and I noted yesterday, the meltup in stock prices over the past year has been an earnings-led meltup rather than a P/E-led meltup. The latter kind usually ends badly with a meltdown. However, the current meltup has been led by strong earnings rather than levitating valuation multiples. So it is likely to be more sustainable than a P/E-led rally.
The most obvious risk is that the fundamentals driving earnings higher will also drive bond yields higher. However, stock prices might actually get a boost from rising bond yields (up to a point) if investors are rotating out of bonds and into stocks. If that happens, then the long-anticipated “Great Rotation” might finally be under way. In any event, let’s review the latest valuation metrics, recognizing that valuation, like beauty, is in the eye of the beholder:
(1) Beastly valuation measures. Let’s start with the ugliest measures, suggesting that stocks are grossly (and grotesquely) overvalued. The Buffett Ratio is equal to the US equity market’s capitalization (excluding foreign issues) divided by nominal GNP (Fig. 1). It is available quarterly and isn’t very timely. In fact, it currently is only available through Q3-2017 when it was 1.78. However, even back then it nearly matched the previous record high of 1.80 during Q1-2000.
A more timely version of this ratio is the ratio of the S&P 500 stock price index to forward revenues (i.e., sales) per share, which is available weekly. This forward price-to-sales ratio (P/S) is only available since January 2004, but it has tracked the Buffett Ratio closely since then. During the first week of January, it rose to a record high of 2.08.
(2) P/S vs P/E. The S&P 500 P/S ratio is highly correlated with the index’s forward P/E, which is about as high as it was in 2004 (Fig. 2). The P/E tends to be about 10 times greater than the P/S (Fig. 3). The same can be said for actual revenues relative to actual earnings (Fig. 4).
That’s not surprising since the E/S ratio is the profit margin of the S&P 500 (Fig. 5). The weekly forward P/S is at a record high while the forward P/E is not because earnings are rising faster than revenues. That’s been mostly attributable to faster global economic growth over the past year, and now going forward will also be attributable to the cut in the corporate tax rate at the end of last year.
As Joe and I noted yesterday, forward P/Es are certainly elevated, with Friday’s readings at 18.5/18.4/20.0 for the S&P 500/400/600 (Fig. 6). However, they are now discounting the improvement in the outlook for forward earnings following the passage of the Tax Cut and Jobs Act (TCJA) late last year.
(3) Inflation-adjusted valuation measures. Of course, P/E and P/S models are essentially reversion-to-the-mean models. They don’t account for inflation and interest rates, which remain historically low. Not only does this boost the discounted value of earnings but it also increases the odds of a longer economic expansion. The longer investors perceive that the expansion can last, the higher the P/Es they’ll be willing to pay.
One model that reflects the impact of inflation is the S&P 500 real yield (Fig. 7). It’s only available through mid-2017, but the market was close to fairly valued back then, and is moving toward overvalued.
Our misery-adjusted P/E model (MAPE) also reflects inflation (Fig. 8). It is simply the S&P 500 forward P/E plus the misery index, which is the sum of the unemployment rate and inflation. MAPE was fairly valued at the end of last year.
US Tax Reform: Rubik’s Cube. The big tax changes in the TCJA are turning Q4 and FY 2017 earnings numbers into an accounting Rubik’s Cube. Under the TCJA, the federal effective statutory corporate tax rate drops to 21% from 35%. The obvious implication is that effective tax rates (ETRs) should decline for most companies. In addition, the tax rate cut will force lots of companies to take one-time earnings hits resulting from non-cash balance-sheet changes. Furthermore, lots of US multinationals will take one-time hits resulting from the newly implemented mandatory transition tax on earnings held overseas.
Analysts have their work cut out untangling the TCJA effects on the financials for the companies that they follow. It helps that public companies are required to footnote the effects of the TCJA, if material, in the notes to the 2017 financial statements. Some companies that have not reported yet are warning investors to expect big forthcoming charges. Here are some examples:
(1) A big hit to DTA. Deferred tax assets (DTA) are balance-sheet accounts where companies may park future expected tax deductions or credits. Net operating losses, for example, are a type of DTA. When a company incurs a net operating loss, tax rules permit corporations to carryforward any “unused” portion of the loss as an offset to future profits. On the balance sheet, the DTA reflects the amount of the “unused” loss multiplied by the tax rate expected to apply to the DTA when it is reversed, or “used up” against future profits.
This is relevant for tax accounting under the TCJA because corporations will need to revalue their DTAs at the new 21% statutory federal corporate tax rate rather than the old 35% rate. “The cumulative adjustment will be recognized in income tax expense from continuing operations as a discrete item in the period that includes the enactment date. Consequently, a calendar year-end company will need to adjust its deferred taxes” in the December 31, 2017 financial statements, according to the accountants at BDO.
During a 12/6 conference, Citigroup’s CFO John Gerspach said that Citigroup “built the DTA at a 35% tax rate.” He stated that at the new tax rate “those losses are going to be worth less than they were when we put them on the balance sheet.” In its earnings report yesterday, Citigroup reported a $22 billion charge from the TCJA. Indeed, the majority of the charge was due to writing down the company’s massive DTAs, mostly composed of net operating loss carryforwards from the financial crisis, reported the WSJ. On 12/22, Goldman Sachs announced in an SEC filing that it would take a $5 billion charge at the end of 2017 for items including “the remeasurement of U.S. deferred tax assets at lower enacted corporate tax rates.”
Not all deferred taxes are on the asset side of the ledger. Deferred tax liabilities (DTL) are the opposite of DTAs. They reflect future expected tax liabilities resulting from current transactions. JPMorgan’s Q4 earnings, reported on Friday, included a $2.1 billion gain for the revaluation of its net DTL.
Corporate financial ratios will also get all twisted up by the revaluation of deferred taxes. For example, Citigroup’s return on equity will get a boost as the company’s DTA is written down. Gerspach explained that the combination of the lower tax rate that’s going to drive higher income and the impact from writing off the DTA is “going to give us a much lower [tangible common equity] going forward, which means that we should get a nice lift in the [return on tangible common equity] going out in 2019 and 2020 … by a couple hundred basis points.”
(2) Territorial tax system. Before the TCJA, “companies owed income tax of up to 35 percent (with a credit for foreign income taxes paid) on profits they repatriate[d] in the form of dividend payments from their foreign affiliates to the US parent company.” Previous accounting rules allowed companies to report net profits to their shareholders that ignored the taxes that they would owe if they were to bring foreign profits back home, observed a Tax Policy Center note. US companies’ overseas earnings could be treated as permanently invested overseas, encouraging firms to accumulate foreign assets.
With the TCJA, overseas earnings are now “deemed” as repatriated as the US transitions to a territorial tax system. EY summarized the change in a 12/16 press release: “US 10%-shareholder’s pro rata share of the foreign corporation’s post-1986 tax-deferred earnings” are to be taxed at a mandatory one-time two-tiered “toll” rate of 15.5% for liquid assets and 8% for non-liquid assets. The tax applies regardless of whether overseas earnings are physically brought back to the US or not and may be paid over a period of 8 years.
In its latest TCJA revenue estimates, the Joint Committee on Taxation (JCT) footnotes that the tax is “effective for the last taxable year beginning before January 1, 2018,” so that would be for the annual period ending December 31, 2017 for calendar-year corporations. Importantly, taxpayers can use net operating loss and foreign tax credit (FTC) carryforwards to offset the transition tax liability, according to BDO.
On JPMorgan’s Friday morning earnings conference call, CEO Jamie Dimon stated that the “impact of tax reform was largely driven by a deemed repatriation of our unremitted overseas earnings.” According to the shareholder presentation, the impact of the tax was $3.7 billion. Dimon explained that “the operative word” is “deemed.” In other words, the overseas earnings will stay overseas “in order to meet local jurisdictional capital and liquidity requirements Separately, Citigroup anticipated the deemed repatriation would cost $3 billion to $4 billion, a non-cash one-time hit to the P&L to be covered by FTCs. Yesterday, Citigroup reported the actual hit to be about $3 billion. Approximately two-thirds of Goldman Sach’s $5 billion hit to 2017 earnings from the TCJA is due to the repatriation tax.
By the way, the repatriation tax is just a part of international income tax reform under the TCJA. Melissa and I are not international tax experts, but like other curious market analysts, we’ve studied the JCT’s estimates for the TCJA as best we can. It shows that the “deduction for dividends received by domestic corporations from certain foreign corporations” will “save” multinationals $223.6 billion. That’s a big offset to the repatriation tax that will “cost” multinationals $338.8 billion. (For a hint at just how complicated it is to account for income taxes, have a skim of Deloitte’s 800+ page guide that was written before the TJCA was passed.)
The Tax Policy Center explained: “The rationale for imposing the one-time tax as part of a transition to a new system is that firms would have paid tax on those profits when repatriated under the previous law. Therefore, the reforms should only fully exempt repatriations of future profits.” Reuters observed on 12/19 that the new tax law “exempts U.S. corporations from U.S. taxes on most future foreign profits, ending the present worldwide system of taxing profits of all U.S.-based corporations, no matter where they are earned. This would align the U.S. tax code with most other industrialized nations, undercut many offshore tax-dodging strategies and deliver to multinationals a goal they have pursued for years.”
(3) Brand new bag. The revaluation of deferred taxes and repatriation tax are really just one-hit wonders and are just the beginning of the tax reform effects. Starting in the 2018 tax year, the drop in the federal statutory corporate tax rate is a big one from 35% to 21%. Even so, ETRs probably won’t drop as much as that for most companies, as we’ve previously explained. JPMorgan’s 2016 effective tax rate was 28.4%, according to an earnings release supplement. It jumped to 31.9% for 2017 including estimated tax expense from the TCJA. For 2018, JPMorgan expects about a 19% rate. and 20% through 2020.
Dimon pointed out that’s about a 10ppt decrease (from 2016 to 2020), which is less than the 14ppt decrease in the federal corporate statutory rate because of the “geographic mix” of JPMorgan’s taxable income among “smaller benefits associated with tax-exempt income and other deductions as a result of the lower absolute rate.” Melissa and I discussed other tax adjustments that will offset the federal statutory corporate rate reduction in our 1/9 Morning Briefing.
January 16, 2018 (Tuesday)
Meltup I: Raising Meltup Odds. I’m getting a lot of emails and phone calls asking if the meltup I started predicting in early 2013 has begun. The short answer is “yes.” So I might as well raise my odds of this scenario from 55% to 70%. I’m leaving my meltdown odds at 25%. So the iron laws of arithmetic leave me with just a 5% probability of a slow-and-steady ascent in stock prices.
I’m not a big fan of meltups. They tend to be followed by meltdowns, which tend to be hard to predict. Meltdowns are usually triggered by a financial crisis, which is also hard to predict. Let’s update the meltup scenario, now that it seems to be under way, and try to assess the likelihood of a meltdown:
(1) Bullish sentiment is absolutely giddy. As Debbie reported last week, the Investor Intelligence Bull/Bear ratio soared to 4.77 during the first full week of January (Fig. 1). That’s the highest reading since March 1987. The latest reading showed that 64.4% of investment advisers were bullish while only 13.5% were bearish. The remaining 22.1% were in the sheepish correction camp. The American Association of Individual Investors also polls investment sentiment; in its measures, recent bullishness readings match previous highs (Fig. 2).
(2) Broad-based rally. The S&P 500 is currently trading at 11.2% above its 200-day moving average, which is among the highest readings of the current bull market (Fig. 3). Furthermore, 77.7% of the S&P 500 companies are trading above their 200-dmas (Fig. 4). That’s also a relatively high reading.
(3) Up, up, and away! The S&P 500/400/600 are up 22.5%, 16.5%, and 15.4% y/y through the week of January 12. These three indexes are up 30.2%, 29.9%, and 33.5% since Election Day (November 8, 2016).
Meltup II: Earnings Melting Up Too. The meltdown scenario is somewhat less worrisome for now, since the meltup in stock prices in recent weeks has been driven to a large extent by a meltup in analysts’ consensus expectations for earnings. Consider the following:
(1) 2018 and 2019. The Tax Cut and Jobs Act (TCJA) passed at the end of last year is already boosting earnings estimates. Joe reports that analysts’ consensus estimates for S&P 500 operating earnings in 2018 rose a whopping $2.13 w/w to $150.15 per share during the first week of January. The estimate for 2019 rose $2.23 to $165.35 (Fig. 5).
Remarkably, revenue estimates also seem to have been boosted, but we think that’s attributable more to animal spirits than the TCJA. Industry analysts are now expecting revenues to rise by 5.7% this year and 4.6% next year, following the 6.3% gain last year.
Through January 4, profit margins are projected to rise from 10.5% for 2017 to 11.2% this year and 11.8% next year.
(2) Forward earnings. On a y/y basis through the second week of January, the 52-week forward consensus expected earnings of the S&P 500/400/600 are up 13.1%, 18.8%, and 15.0% (Fig. 6). So they account for much of the increase in their respective stock price indexes over this period.
As a result, forward P/Es are elevated, but aren’t much higher than a year ago (Fig. 7). The S&P 500 has a forward P/E of 18.5 currently, up from 17.1 a year ago. On the other hand, the S&P 400 and 600 forward P/Es are basically unchanged at 18.4 and 20.0 now vs 18.8 and 19.9 a year ago.
(3) Sectors showing widespread forward earnings improvement. Here are the y/y changes in forward earning per share for the 11 S&P 500 sectors as of January 4, from highest to lowest: Energy (22.9%), Tech (20.7), Financials (16.3), Materials (12.7), S&P 500 (11.6), Industrials (9.2), Consumer Staples (8.1), Utilities (6.4), Consumer Discretionary (4.8), Health Care (4.2), Real Estate (2.9), and Telecom (-0.4) (Fig. 8).
Joe observes that even before the Trump tax cuts, earnings estimates were being revised higher, especially in the S&P 500 Energy, Financials, Industrials, and Materials sectors (Fig. 9). The upward revisions in these cyclical sectors were largely attributable to the rebound in global economic activity, which drove up oil and other commodity prices. The tax cuts have added to the excitement on expectations that they will boost after-tax results.
Meltup III: Companies Are Paying it Forward. The most extraordinary development since the Trump tax cuts were passed is that several corporations have announced that some of their windfalls resulting from the cuts in the corporate tax rate as well as the tax on repatriated earnings will be paid out to employees in bonuses and wage increases. Many of their employees will also see more after-tax pay, resulting from the increase in the standard deduction and the lowering of individual tax rates.
This increases the likelihood of stronger economic growth in coming months, which will also be good for earnings. In other words, we may be experiencing an extremely unusual earnings-led meltup. If so, it is more likely to be sustainable than the run-of-the-mill P/E-led meltup, as long as it doesn’t morph into one. We’ll let you know if it does. For now, sit back and enjoy the show.
Meltup IV: Running Hot. There is clearly a coincidence between Trump’s election and the run-up in stock prices over the past year. However, coinciding with Trump’s victory was mounting evidence of a global synchronized boom. In our opinion, the run-up in stock prices over the past year has been a continuation of the bull market within a bull market that started on February 12, 2016. Since the bottom the day before, the S&P 500/400/600 are up 52.3%, 58.7% and 64.8%.
In our view, 2015 was the “growth recession” year for the global economy attributable to the bursting of the commodity supercycle. Then 2016 was the recovery year for the global economy. Last year was the expansion year, and this year is shaping up to be the boom year. Consider the following:
(1) Commodity prices. The CRB raw industrials spot price index fell sharply during 2015 (Fig. 10). It rebounded during 2016, stalled during 2017, and has rebounded in the past couple of weeks.
(2) Eurozone. During November, industrial production in the Eurozone rose 1.0% m/m and 3.2% y/y to a new cyclical high (Fig. 11). The volume of retail sales (excluding autos and motorcycles) in the region jumped to a record high that same month (Fig. 12).
(3) US GDP. At the end of last week, following the December retail sales and CPI releases, the Atlanta Fed’s GDPNow estimate for Q4 real GDP rose from 2.8% to 3.3%. Retail sales continue to grow along with the solid gains in wages and salaries, which just got a big boost from the TCJA, as noted above (Fig. 13).
Meltup V: 666 Again! The stock market is going a lot higher based on my 666 indicator. I turned bullish on the S&P 500 index after it fell to an intra-day low of 666 on March 6, 2009. I reiterated my bullish stance during January 2016, when I checked in to the Zurich Radisson Hotel and was assigned Room #666. Last Wednesday, I returned from a business meeting in Florida, and I noticed the bookstore at the airport was promoting a novel titled Lucky 666: The Impossible Mission. I’m still predicting 3100 on the S&P 500. But in a meltup scenario, I wouldn’t be surprised to see 3330, as that is 666 times 5.
Movie. “The Post” (+) (link) is a movie about fake news. However, it is about fake news concocted by the US government about its goals and actions during the Vietnam War, rather than by the press. The New York Times and The Washington Post exposed the government’s systemic lying about the scope of its involvement in Vietnam by releasing the Pentagon Papers, which was a history of the Vietnam War conducted by the Defense Department. The movie features Meryl Streep as Katherine Graham, the owner of the Post, and Tom Hanks as Ben Bradley, the editor of the newspaper. It was produced by Steven Spielberg. It’s a cri de cœur for freedom of the press, which has plenty of freedom today as well as a very loud critic in the Oval Office.
January 11, 2018 (Thursday)
Tech Focus: Talking Showers. The Consumer Electronics Show (CES) is a great way to start a year because it’s full of optimism about exciting new innovations and updates of old ones. Some of the new products displayed at CES are jazzed-up versions of the mundane: a shower head that has Alexa imbedded in it so it responds to voice commands to turn on at a certain temperature, a suitcase that rolls behind a traveler like a dog, and a “smart” refrigerator that knows if it’s time to buy more milk.
Other items introduced at CES—even if they may not be sold anytime soon—are awe inspiring and have the potential to dramatically change the world in which we live. Changing the way people and goods are transported was a major theme of this year’s CES. Fisker has an electric car run on a solid-state battery that boasts 500 or more miles per charge at a lower cost than current alternatives. Nvidia’s CEO discussed how the company’s chips are in autonomous cars. Ford’s CEO went bigger picture, delving into how cars, streets, and cities could be connected wirelessly to make transportation systems work better—if we are willing to give up some privacy. And Intel’s CEO introduced an autonomous, flying taxi. Hello, Jetsons!
The CES news coverage and strong upward earnings revisions undoubtedly helped propel the S&P 500 Technology stock price index ahead of all other S&P 500 sectors early in the new year (Fig. 1). Here’s the performance derby ytd through Tuesday’s close: Tech 4.3%, Energy (4.2%), Health Care (4.0), Materials (3.9), Industrials (3.8), Consumer Discretionary (3.5), S&P 500 (2.9), Financials (2.3), Consumer Staples (0.1), Real Estate (-2.5), Utilities (-2.6), and Telecom Services (-3.0) (Fig. 2).
The FANGs (Facebook, Amazon, Netflix, and Alphabet, parent of Google) and a few other tech stocks have performed even more impressively than the Tech sector at large. Ytd through Tuesday’s close, Facebook is up 4.5%, Amazon.com (7.1%), Netflix (9.0), Alphabet (5.7), Nvidia (14.7), and Tesla (7.2).
The FANG stocks have become increasingly important to the S&P 500, according to Joe’s calculations. FANG shares represented 8.7% of the S&P 500’s market capitalization on January 4, up from 4.0% at the beginning of 2015. The market cap also looks outsized relative to the four stocks’ earnings, which equate to only 2.7% of S&P 500’s earnings and 0.3% of its revenue (Fig. 3). I asked Jackie to take a look at what’s got FANG investors so excited:
(1) Mirror, mirror on the wall. Amazon has Alexa, Google has Assistant, Apple has Siri, Samsung has Bixby, and Facebook has created Portal. Now all of the voice assistants need to be kept busy. CES showcased a raft of products that have assistants imbedded in them. For example, Kohler has a mirror, which when asked, can play music, turn a shower on to a specific temperature, and adjust the brightness of the lights. The mirror uses Alexa and will eventually have Google Assistant as well, a 1/8 WSJ article reported.
Expect to do a lot of chatting with appliances in the near future. A 1/8 Wired article explained: Amazon has “created a new division called Alexa Voice Services [AVS], which builds hardware and software with the aim of making it stupendously easy to add Alexa into whatever ceiling fan, lightbulb, refrigerator, or car someone might be working on. ‘You should be able to talk to Alexa no matter where you’re located or what device you’re talking to,’ says Priya Abani, Amazon’s director of AVS enablement. ‘We basically envision a world where Alexa is everywhere.’” The company has about 50 third-party Alexa devices on the market and seems to have the lead.
Jackie reports, “The importance of voice assistants was clear after I asked my son a question. I would have used my phone’s web browser to find the answer. He immediately asked Siri for the answer. If turning to a voice assistant for information becomes second nature, could it result in the disruption of Google’s web advertising business in 2018?”
Both Amazon and Alphabet have numerous other fast-growing businesses, including Amazon Web Services and YouTube. Amazon shares, up 57.2% y/y, trade at 156.8 times this year’s expected earnings per share of $7.99, while Alphabet’s shares, up 37.1% over the same period, trade at 26.7 times its expected EPS of $41.48. Amazon’s earnings are forecasted to grow by 85.8% y/y, while Alphabet is expected to boost earnings by 28.7%.
(2) Chips, chips everywhere. We’ve long favored semiconductors, which had a banner 2017. The S&P 500 Semiconductors index rallied 33.4% last year, and the Semiconductor Equipment index soared 57.8%, bolstered by strong earnings growth (Fig. 4). The more intelligent inanimate objects get, the more semiconductors they’ll need. Autonomous cars consume vast quantities of data, and it’s likely they’ll be driving in “smart” cities where cars, signs, streets, bikes etc. all will communicate wirelessly.
Two of the semiconductor industry’s titans spoke at CES: Nvidia’s CEO Jensen Huang and Intel’s Brian Krzanich. Nvidia earned its chops designing GPUs—graphic processing units, used to run computer games. While Huang touched on gaming in his CES presentation, he spent more time with Volkswagen’s CEO Herbert Diess, who joined Huang on stage to discuss how Nvidia’s chips would be used in VW’s autonomous, electronic bus. Huang also announced Nvidia’s new partnership with Uber, which is also working on self-driving technology.
When Intel’s Krzanich took the stage, he had to explain how the company planned to patch products that had security flaws. Later, however, he invited Mobileye’s CEO Amnon Shashua on stage together with an autonomous car powered by Mobileye’s technology. Intel bought Mobileye last year for about $15 billion, and the technology is in many of the major auto companies’ cars.
But what was truly imagination-capturing was a video of Krzanich riding in a volocopter—an autonomous, battery-powered air taxi made by Volocopter GmbH. It rose vertically, like a helicopter, but looked like a large drone that had room for two passengers. It uses Intel technology and can be summoned with a cell phone app. Autonomous vehicles, whether driving or flying, require the ability to absorb vast amounts of data, and he who designs the smallest, most robust, and most energy-efficient system will win the day.
The stocks of Intel and Nvidia have had very different years. Intel shares are up 19.2% over the past year, trounced by the 106.9% surge in Nvidia shares. Intel shares trade at 13.4 times 2018 earnings, which are flat y/y, while Nvidia shares trade 47.3 times this year’s earnings, which are expected to grow by 11.9%.
(3) Under fire. The FANG constituents each may have started out perfecting a service or product in their own, unique silos. But CES made it clear that the tech giants, in an effort to attract new eyeballs or keep old eyeballs for longer periods, are forcefully elbowing into each other’s territories.
As we mentioned above, most of the tech giants are peddling their own voice assistants. Many also have jumped into the market for virtual reality headsets. Facebook, for example, bought Oculus, a virtual reality (VR) company for $2 billion in 2014, and at CES it launched its first VR headset for the Chinese market, according to a 1/8 Recode article. Google, the king of search, also has its own VR headset offerings. Meanwhile, Apple, the consumer product company, is reportedly working on an augmented-reality headset.
Entertainment is another area that the tech titans are swarming into in hopes of holding eyeballs for longer periods. Facebook announced it will livestream college basketball games for free this season. Alphabet’s YouTube, Amazon Prime, and Netflix have all gotten into the business of making movies, with Amazon’s Jeff Bezos attending the Golden Globes last weekend. And even Disney has gotten into streaming, with plans to pull some of its content off of others’ streaming services, and instead stream the content directly to customers itself. Dare we say, there’s too much content floating around the Internet.
Were that not enough, some of the largest tech titans have become punching bags for regulators and industry watchers. Facebook has been criticized for “ripping apart society” with addictive programs that make us envious of the perfect lives posted online. Apple came under fire for slowing down the performance of old phones without alerting users and for not helping parents limit children’s use of the phone. Advertisers were up in arms when they realized Google was allowing their ads to share screens with inappropriate YouTube videos last year. And the ultimate knockout punch came last month when the FCC repealed net neutrality regulations, which required communications companies to treat all web traffic the same when distributing and charging for it. Just how this will affect the tech giants may determine whether their outsized stock gains can continue.
Facebook shares have climbed by 50.2% y/y through Tuesday’s close, on par with Netflix’s 59.8% rise. Facebook trades at 28.3 times the $6.63 a share analysts expect it to earn this year, while Netflix’s multiple is 91.0 times this year’s projected earnings. Facebook is expected to grow earnings by 12.8% y/y in 2018, while Netflix is expected to grow them by a much speedier 81.1%. No one said getting older was easy.
Revisiting Animal Spirits
January 10, 2018 (Wednesday)
Zoology 102: Still Roaring. A year ago, we all noticed a remarkable heightening of “animal spirits.” Surveys of consumer and business confidence soared during November and December of 2016 and continued to do so during January 2017. It was hard to deny that Trump’s victory in the presidential election had a lot to do with the euphoria. The latest readings show that the animals are either as euphoric or more so than they were a year ago.
A year ago, we all noticed that the euphoria—widespread except among Hillary’s supporters, of course—wasn’t showing up in the “hard” data. Economic indicators were signaling lackluster growth. Last year, the Citigroup Economic Surprise Index (CESI) fell to a low of -78.6 on June 16 (Fig. 1). Real GDP rose just 1.2% (saar) during Q1 (Fig. 2). However, since last year’s low, the CESI soared to a recent high of 84.5. It was 73.9 on Monday. Real GDP rose 3.1% during Q2 and 3.2% during Q3 last year, and the Atlanta Fed’s GDPNow is estimating Q4 growth of 2.7%, down from 3.2% on January 3. (The next estimate is due out today.)
Interestingly, consumer and business surveys remained upbeat even last spring and summer when Trump’s economic agenda seemed to be sinking in Washington’s swamp. His success in passing a major tax reform plan at the end of last year is likely to keep sentiment elevated, and it could also stimulate more economic growth this year. Debbie and I aren’t ready to join the 4-percenters, but we are solidly in the 3-percent camp.
Did you notice that since Trump was elected, there is much less chatter about the “new normal” and about “secular stagnation?” It is looking more and more like the old normal, with the economy showing signs of a late-cycle boom. The big difference so far is that there are almost no signs of a late-cycle rebound in inflation. No wonder that spirits and prices in the stock market are soaring so.
Without any further ado, let’s revisit the zoo to gauge the sentiment among the various inhabitants:
(1) Consumer sentiment. During December, both the Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI) were well above their year-ago levels. Debbie and I derive our Consumer Optimism Index (COI) by averaging the two (Fig. 3). Our index was 109.0 during December vs 105.8 a year ago. The current conditions component of the COI rose to a cyclical peak of 135.2, the highest since March 2001.
Debbie and I like the CCI more than the CSI because the former is more sensitive to labor market conditions. We are particularly fond of the CCI survey’s series on whether respondents believe that jobs are plentiful, available, or hard to get (Fig. 4). The latter fell last month to just 15.2%, the lowest reading since July 2001. The jobs-are-hard-to-get series is highly correlated with the unemployment rate, which was 4.1% last month, at the lowest level since December 2000 (Fig. 5). Both are signaling that the labor market is very tight.
(2) Small business optimism. The monthly NFIB survey of small business owners confirms that they are having a tough time finding workers. The December survey found that the percent reporting that there are few or no qualified applicants for job openings rose to 54.0%, the highest in the history of the series going back to April 1993 (Fig. 6). The monthly survey asks respondents to indicate their biggest problem (Fig. 7). During December 2015, government regulation and taxes tied for first place at 21.2%. At the end of last year, the former was down to 15.7%, while the latter was still high and number one at 21.0%. Undoubtedly, that response will come down significantly now that tax rates have been cut for corporations and sole proprietorships. So while the NFIB survey doesn’t include “workers are hard to get” as a response, that may very well be the only significant problem facing small businesses!
(3) CEO survey. The CEO economic outlook index compiled by the Business Roundtable rose to 96.8 during Q4-2017 from 74.2 the year before (Fig. 8). This index is highly correlated with the growth rate in capital spending in real GDP on a y/y basis. Sure enough, the latter rose to 4.6% during Q3-2017, up from a recent low of -1.2% during Q1-2016.
(4) Purchasing managers indexes. Purchasing managers also are displaying signs of elevated exuberance, particularly in the manufacturing sector, where the M-PMI rose to 59.7 during December, up from 54.5 a year ago (Fig. 9). Even more impressive is the new orders component of the M-PMI, which rose from 60.3 a year ago to 69.4 during December.
(5) Forward earnings and revenues. Industry analysts have been increasingly upbeat about the prospects for revenues for the S&P 500, and so too for earnings, especially now that the corporate tax rate has been cut by the Tax Cut and Jobs Act (TCJA) (Fig. 10 and Fig. 11). Even our very own mild-mannered Joe is getting excited about what he is seeing in the latest numbers: “Since the passage of the TCJA, the pace of change in the forward earnings estimate has accelerated. Even better, consensus annual earnings forecasts are rising on an absolute basis instead of posting declines as they typically did in past years. The three-week change (since the TCJA) in forward earnings is 1.8% for LargeCap, 1.4% for MidCap, and 2.3% for SmallCap. That marks LargeCap’s biggest three-week change in forward earnings since May 2011.”
(6) Forward P/Es and LTEG. Forward P/Es are rising, but not as fast as stocks because earnings estimates are on the rise. Valuation multiples are determined by investors, while consensus earnings estimates are determined by analysts. Analysts have also turned more bullish about the prospects for S&P 500 earnings growth over the next five years. During December, they projected an average annual growth rate of 12.9%, up from 12.0% from a year ago.
Last year, in our 11/7 commentary, I wrote: “It may be time to consider the possibility that the US economy is finally entering a boom phase. We aren’t there yet, but there is evidence that the pace of real economic activity is quickening. …. The test of my boom hypothesis might be the performance of the economy during Q1-2018. The first quarter has been a clunker since the start of the current expansion. …. There’s definitely a strange pattern of weakness during Q1 even though the data are seasonally adjusted. Debbie and I will be monitoring the hard data during Q1 to see whether the first-quarter curse disappears, as we expect it might given the mounting signs of an economic boom.” We will keep you posted.
Tax Reform: What's Really in this Sausage?
January 9, 2018 (Tuesday)
US Tax Reform I: Temporary Offsets. Now that we are all back from our holiday vacations, our first New Year’s resolution is to make sense of what made it into the Tax Cuts and Jobs Act of 2017 (TCJA) at the end of last year. Most of the Act’s provisions take effect immediately during the current tax year.
Melissa and I followed the sausage making in Congress as best we could late last year, when the differences were reconciled between the House and Senate bills in a conference committee. Signed into public law by President Donald Trump on December 22, the TCJA has been referred to as the largest tax reform effort since the 1980s. Now it’s time to taste the sausage.
Let’s skip over the legislation’s many moving parts for now and focus first on the changes that will impact corporations most significantly. On its website, the US Senate Committee on Finance supplies helpful links including the Joint Committee on Taxation’s (JCT) score of the legislation’s conference report. Of course, the most substantial change to the tax code is the reduction in the statutory federal corporate tax rate from 35% to 21%.
On a static basis, the JCT expects the rate reduction to lower the corporate tax bill by $1.3 trillion over the next 10 years. That’s a nice chunk of change, but it’s not the complete picture. That’s because the tax rate that companies actually pay may be lower, or even higher, than 21% depending on other tax adjustments. The change in the corporate tax rate is to remain in place from 2018 onward.
Interestingly, the big offsetting adjustments mostly impact the timing of tax liabilities rather than the amount of those liabilities over the long term. Here’s a quick rundown of the offsetting corporate tax reforms for which the JCT estimates budget effects greater than $100 billion over the fiscal years 2018 to 2027:
(1) Limit net interest deductions to 30% of adjusted taxable income (AGI). Companies could deduct an unlimited amount of interest expense from their tax bill under the old tax code. Now the deduction is limited to 30% of AGI for most large companies, excluding utility and real estate companies. Offsetting the lower corporate tax rate, the JCT expects the change to increase the corporate tax bill by $253 billion over 2018 to 2027.
A 12/21 article in the WSJ discussed the adverse effects the new limitations could have on debt-laden companies like Dell, Tenet Healthcare, and JC Penney. In a report dated July 2017 (when Congress was still contemplating the complete elimination of interest deductibility), Moody’s observed that the loss of interest deductibility would be a “blow” for speculative-grade companies. Sectors with the highest leverage, including healthcare and technology, would be “among the most exposed.”
However, Barron’s reported on 11/4 that Morgan Stanley estimates less than 4% of S&P 500 companies with an investment-grade credit rating would be affected by the cap on interest deductibility—but about one-third of the high-yield universe would be. The burden would get worse for speculative-grade companies when earnings fall or during periods of loss, when the deduction would be completely disallowed. Even so, “the amount of any business interest not allowed as a deduction for any taxable year … shall be treated as business interest paid or accrued in the succeeding taxable year,” according to the conference report. That means that companies can carry it forward.
(2) Modification of net operating loss (NOL) deduction. Over the next 10 years, modifications to NOLs are expected to increase the corporate tax bill by $201 billion, another significant offset to the corporate rate reduction. The conference report notes that the deduction for NOLs will be limited to 80% of taxable income before any allowable NOL deduction during a tax year. Previously, NOLs could be used to offset it all. So a company with $900,000 of income in 2019 and a $1 million net operating loss from 2018 as an available offset could still end up paying tax on $180,000 of income (or 20% of $900,000) on its 2019 tax return. That’s a simple calculation similar to one Forbes presented on 11/3, when a 90% limitation was under consideration.
Further, carrybacks, which were previously permitted for up to two prior years, are no longer permitted. Carrybacks are current-year losses that are used as an offset against prior-year profits. Carryforwards, however, will be made indefinite rather than limited to 20 years. (Carryforwards are current losses used as an offset against future-year income.)
(3) Amortization of research and experimental (R&E) expenditures. First enacted in 1981, the R&E credit was temporarily extended 16 times before being made permanent in 2015, observed a 10/12 US Treasury analysis. Starting in 2022, according to the conference report, the full R&E credit will no longer be allowed.
Instead, the taxpayer shall charge such expenditures to a capital account to be amortized over five years (with a 15-year period imposed for certain types of expenditures). In other words, the R&E credit is not completely forgone, but spread out over time. The JCT expects the rule change to increase the corporate tax bill by $120 billion from 2022 to 2027.
Notably, the section does not apply to ascertaining the location or extent of minerals, so oil and gas companies continue to get the immediate credit. For technology companies, software development must be classified as “R&E” and amortized according to the rules. Manufacturers and pharmaceutical companies are not specifically mentioned in this section of the conference report, but they also are known for extensive R&E.
US Tax Reform II: Front-Loaded Benefits. One of our accounts forwarded a 12/18 brief on the Penn Wharton Budget Model’s (PWBM) estimate of the federal corporate effective tax rate (ETR) across 19 main industrial sectors. So far, the study is one of the most helpful that Melissa and I have come across for understanding how the TCJA will impact ETRs by sector and over time. It confirmed our thinking that the macro corporate federal ETR is already significantly lower than the previous statutory rate of 35%. Under 2017 law, it averages about 23%, according to the PWBM’s calculations (see our technical note below). However, there is a significant variance among industries, in a range of 18% to 33%.
Under the TCJA, the average ETR falls from 21% to 9% in 2018, according to the PWBM. However, by 2027 the ETR doubles in value to 18%, mostly due to the timing of the TCJA’s provisions. For certain capital-intensive industries, the average ETR actually rises above the statutory rate in future years for the reasons discussed below. For all industries reviewed, ETRs are reduced in the long term from 2017 levels. But more than half of the effectiveness of the corporate tax cut is “undone” within 10 years, according to the PWBM. Consider the following:
(1) Big upfront bonus depreciation. The largest business tax break that changed under the TCJA, aside from the rate reduction, is bonus depreciation. By the JCT’s account, the extension, expansion, then phase-down of bonus depreciation save corporations $86 billion over 10 years. Before the TCJA, businesses could claim a 50% first-year bonus depreciation deduction for qualified new assets placed in service in 2017. It was available for the cost of computer hardware and software, vehicles, machinery, and equipment, among other expenses, highlighted a note from The CPA Desk.
Now, under the TCJA, for qualified property placed in service between September 28, 2017 and December 31, 2022, a 100% deduction may be taken in the first year. And the deduction is expanded to include used property as opposed to only new property under the old rules. The TCJA also expands the type of property that may qualify for bonus depreciation. Starting in 2023, bonus depreciation is set to be reduced annually by 20 percentage points until it is phased out by the end of 2026. While there are nuances to the changes, that’s the essence of them.
According to the PWBM, the expiration of the 100% first-year bonus depreciation provision under TCJA is one of the main reasons that ETRs are expected to rise after 2022. The PWBM brief explains: “At first glance, the higher effective rates in 2023 and 2027 seem counterintuitive. However, they reflect the fact that a portion of depreciation deductions can no longer be taken since the investments were fully expensed in prior years. … Of course, companies are better off in present value terms, since an immediate tax reduction is more valuable than a future reduction. However, much of the short-run reduction in ETR values simply reflects a shift in timing of depreciation allowances rather than an average reduction in the long run.”
(2) Higher ETR than statutory? Capital-intensive industries—such as utilities, real estate, transportation, agriculture, and healthcare services—stand to benefit the most from full expensing. “These industries see at least a 12.8 percentage point drop in effective rate, but by 2027 these industries give back most of the ETR drop realized in 2018,” according to the PWBM. For these industries, effective rates actually rise above the statutory rate for two reasons:
“First, for capital investments that were fully expensed, no future depreciation is allowed, but future book income is still net of economic depreciation in future years. Second, the limitation on net interest deductions increases taxes even though book income is net of interest payments. In fact, some industries that are relatively heavily debt financed, including agriculture, see their ETR’s increase above the statutory rate even before expensing begins phasing out,” noted the brief.
(3) Big bucks for some. The brief observes that ETRs for manufacturing and mining decrease less than average across industries, because these industries already have low ETRs. “The benefit these industries see from a drop in the statutory rate is restricted by both the limitation of net interest deduction beginning in 2018 and the change in the treatment of research and experimentation expenses beginning in 2022. Manufacturing, in particular, accounts for almost two-thirds of research costs, which are fully deductible under current law. Under TCJA, those costs must be capitalized over a period of five years, sharply reducing the tax benefit received by manufacturers.”
Nevertheless, in dollar terms, the largest beneficiary of the TCJA, according to the PWBM, is manufacturing. About $262 billion in tax savings is expected for manufacturing, or about 20% of the tax reduction for all corporations’ taxes. Finance and insurance also gain nearly $250 billion.
(4) Technical note. The PWBM’s method for calculating ETRs mirrors the one used by the US Treasury (see here) except that the PWBM focuses on federal corporate taxes only. Like the Treasury, the PWBM “neutralizes” for NOLs by taking them out of the equation. NOL values are multiplied by the applicable statutory federal corporate rate and added back to the numerator of taxes paid. That means that in tax years that generate substantial NOLs, the effective rate would have been lower under the PWBM method if the NOLs had been included.
US Tax Reform III: Buybacks Back. As a result of the tax reform, companies will experience a domestic cash windfall from the mandatory repatriation of cash held overseas. Additionally, most companies will enjoy a significantly lower effective tax rate for some time. The important questions that we are all trying to answer are: What will companies do with the extra cash from the tax reform and will that boost earnings? The stock market? The US economy? The answer may be “yes” to all of the above, but primarily for the short term.
Typically, corporate finance textbooks dictate a few main options for putting extra cash to work, including paying it forward to employees, increasing capital spending (organically or via M&A), and returning it to shareholders or to debtholders. Of the options, several companies have advertised that they’ll be engaging more heavily in all but capital spending.
It’s not hard to understand why: Companies already have had access to super-cheap debt, given low interest rates, for some time now. Corporate balance sheets are not wanting for cash, so capital already is available to invest. Might tax reform be solving a capital investment funding problem that just isn’t there?
In late October, Marriott’s CEO summed it up at Yahoo Finance’s All Markets Summit: “From our perspective, we’re not cash starved, we have plenty of resources, and therefore where we’ve got an opportunity to invest and it makes sense for our business model, we’re investing.” The CEO added that with tax reform the company “probably wouldn’t incrementally invest” but instead “return it to our shareholders.” That’s in line with what other executives are indicating. Consider the following:
(1) Shareholder appreciation. Recent history has proven that companies have tended to favor share buybacks in the low-interest-rate environment. Buyback enthusiasm has recently tempered, but it might just pick up again under the tax reform. Lots of promises to shareholders were found in a summary of corporate executive comments compiled by the Washington Post’s Heather Long on 12/21. Bloomberg Intelligence analysts predict that share repurchases could increase by more than 70% on an annualized basis as a result of the tax overhaul.
Such a jump “increases the appeal of equities relative to other classes,” pointed out Bloomberg Intelligence’s chief equity strategist. We’ve been arguing for some time that buybacks have fueled the equity bull market. Major companies, including Amgen and Honeywell, have said they plan to use the corporate tax savings windfall to benefit shareholders, according to Reuters in October. Large technology companies with a significant international presence and lots of cash stashed overseas “may spearhead the growth in the rate of buybacks,” observed Bloomberg.
(2) Pay it forward. None of the 17 companies that responded to Reuters’ inquiry during October planned to boost headcount with the tax savings. But several, including AT&T, planned to pay employee bonuses in tandem with the tax overhaul—which may reflect timing more than the most significant uses of the extra cash in coming years. That’s because committing to the bonus payments during 2017 may allow companies to record the expense during 2017 for tax purposes, as a 12/21 WSJ article discussed. “I can guarantee you [that companies] are doing everything they possibly can to accelerate deductions before the end of the year,” said a North Carolina State University accounting professor specializing in corporate taxes who was quoted. Notably, the new legislation makes it more difficult for companies to deduct over $1 million in compensation for executives.
(3) Pay down debt. During October, Exxon Mobil’s Vice President of Investor Relations said: “The first things that are being funded are our dividends and our investment program. And if there’s any cash left at that point given that the corporation does not want to hold large cash reserves, it’s at that point that we will look for what the next best thing is. And maybe if we have some debt maturing, we’ll pay that debt down.” Indeed, some companies may be more inclined to pay down debt given the new limitations on interest expense.
(4) Increase capital spending. Anecdotally, Gary Cohn asked a room of CEOs in November to raise their hands if they planned to increase investment upon tax reform. Very few hands went up, and Cohn looked surprised, reported the Washington Post.
Some companies, however, have signaled that they see room for additional investment. For example, during November, CVS Health’s CFO said: “To the degree that we have [tax] relief, there’s a lot of investments that we think we can make within our business model that can more rapidly expand our business model across the country and deliver better care and higher quality and lower cost. So we would look to take the benefit of that and invest it clearly.”
The comments captured above were all made late last year, before tax reform was official. Now that it is, and corporate earnings season is underway, we will be listening closely to earnings calls for indications of solid corporate plans for the extra cash.
January 8, 2018 (Monday)
Strategy I: Tuning Out the Noise. Fire and fury raged inside the Beltway last week in the form of a new book about President Donald Trump. Michael Wolff in Fire and Fury: Inside the Trump White House essentially claims that the President is “an idiot surrounded by clowns,” as one unnamed source puts it. It’s a caricature, but so is the President. There’s nothing new in Wolff’s book that isn’t already widely known. We know that Trump tends to have the childish disposition of a school-yard bully. We know he is thin-skinned, and feels a need to respond to every criticism.
Psychiatrists are popping up all over the mainstream press claiming that the new book confirms that the President suffers from attention deficit disorder and narcissism. Trump isn’t exactly the first president to be a narcissist. But he is the first to tweet lots of off-the-wall messages on a daily basis. Last Monday, North Korea’s deranged leader Kim Jong Un said he had a button ready to launch nuclear weapons installed in his desk. The next day Trump tweeted that he, too, has a nuclear button, “but it is a much bigger & more powerful one than his, and my Button works!”
Responding to questions about his mental health on Saturday, Trump tweeted, “Actually, throughout my life, my two greatest assets have been mental stability and being, like, really smart.” He said he was a “VERY successful businessman” and television star who won the presidency on his first try. “I think that would qualify as not smart, but genius....and a very stable genius at that!”
What if Trump is right, and all his critics are wrong? I know that sounds crazy, so perhaps I need to have my head examined. Then again, so should Mr. Stock Market! Apparently, investors aren’t worried that our President is deranged. The market’s performance suggests they think Trump is crazy like a fox. How else to explain that the S&P 500 is up 28.2% since Election Day, November 8, 2016 to yet another record high on Friday (Fig. 1)? The Nasdaq is up 37.4% over the same period (Fig. 2). Here’s the performance derby of the S&P 500 sectors since Election Day: Information Technology (44.2%), Materials (33.0), Industrials (30.4), Consumer Discretionary (29.5), S&P 500 (28.2), Health Care (25.1), Consumer Staples (8.7). Energy (8.6), Real Estate (6.5), Telecom Services (4.7), and Utilities (4.6) (Fig. 3).
Money flows also suggest comfort with Trump. Equity mutual funds and ETFs attracted $315.1 billion over the 12 months through November 2017 (Fig. 4). Money is still coming out of equity mutual funds, but that’s more than offset by hefty inflows into equity ETFs (Fig. 5). They attracted $355.8 billion over the past 12 months, with $197.8 billion going into equity ETFs that invest domestically and a record $158.1 billion into those that invest globally.
The interest in investing globally confirms that the stock market rally since November 8, 2016 isn’t all about Trump. Trump may think it is, but the rally has been mostly driven by rising earnings expectations as the global economy has continued to show more and more signs of booming without reviving inflation. In other words, while Washington is generating lots of noise, the global economy is providing a clearly bullish signal for earnings and stock prices:
(1) World stock prices. Since November 8, 2016, the All Country World ex US MSCI stock price index is up 23.9% in local currency and 28.1% in dollars (Fig. 6). Here is the performance derby over this period for the major MSCI stock market indexes in dollars: EMU (33.4%), Emerging Markets (33.1), US (28.1), World (27.4), Japan (26.1), and UK (23.0). In dollars, the rest of the world has been mostly outperforming the US, though much of that outperformance was attributable to the weaker dollar (Fig. 7). In any event, foreign equity markets’ solid gains certainly have more to do with the global synchronized economic boom than Trump’s presidency.
(2) Global PMIs. Debbie and I believe that the global economy fell into an energy-led growth recession during 2015. That was followed by a global synchronized recovery in 2016 and expansion during 2017. This year, there could be a global synchronized boom based on the strength shown late last year in many economies around the world. That’s confirmed by the global composite PMI, which rose to 54.4 during December, up from a recent low of 50.6 during February 2016 (Fig. 8). Leading the way higher over this period has been the global M-PMI, which rose from 50.0 to 54.5.
(3) Dr. Copper. The nearby futures price of a pound of copper rose to $3.29 on December 28, the highest since February 25, 2014 (Fig. 9). It’s up 28% y/y.
(4) Forward revenues and earnings. It’s too soon to tell how the cut in the corporate tax rate late last year will affect the consensus earnings estimates of industry analysts. Undoubtedly, they will be raising their estimates. But they may wait until they get more guidance from company managements during the Q4 earnings season this month. At the end of last year, weekly S&P 500 forward consensus earnings estimates through the 12/28 week resumed their relatively flattish trends during most of 2017 for both 2017 and 2018 (Fig. 10). Earnings estimates for 2019 have been moving noticeably higher during the final weeks of last year.
At the end of last year, industry analysts predicted that S&P 500 operating earnings per share will rise this year by $15.76 (or 12.0%) to $147.23 and next year by $14.99 (10.2%) to $162.23. (Joe and I are using $147.00 for this year and $157.50 for next year. We are assuming that the cut in the corporate tax rate will add $6 per share to this year’s earnings.)
Forward earnings—which will soon be calculated as the time-weighted average of 2018 and 2019 estimates—rose to a record high of $147.23 per share at the end of last year. It has been tracking the record-setting trend of forward revenues all last year. Those revenues won’t be affected by the tax cut as much as earnings will be in 2018. So we will be watching both of them closely in coming weeks. For now, it’s clear that the solid gains in both last year reflected the strengthening global economy.
Strategy II: Less Panic Prone. Crying “Wolf” no longer rattles the stock market. Joe and I continue to count the number of panic attacks in the current bull market in stocks, which started in 2009. We ambiguously define them as any significant selloff tied to panic-worthy news. There have been 59 of them by our count. There were only two short ones in 2017. (See our S&P 500 Panic Attacks Since 2009.)
Back in early 2013, when the panic attack about the “fiscal cliff” late in 2012 proved unjustified as fears didn’t pan out, I argued that we have nothing to fear but nothing to fear. I started to discuss the possibility of a meltup.
Interestingly, the market had another great day on Friday despite the fire and fury coming out of Washington about the President’s mental capacity. Instead, the market might be responding very positively to the tax reform plan passed late last year. Now there is talk of moving on to welfare reform and an infrastructure spending program. There is also more talk starting between North Korea and South Korea.
The Q4 earnings season is just starting, and investors are anticipating that many companies will be taking one-time charge-offs on deferred tax assets, but will have a lower tax rate for the foreseeable future. A few companies have announced that some of their tax windfalls will be used to make bonus payments to their workers. Some companies are likely to talk about how much money they expect to repatriate from abroad, and whether those funds will be used for buying back shares and paying out more dividends.
For all of these reasons, it’s hard to convince investors that they should be afraid of the big bad wolf.
Unemployment & Inflation: Heavenly Match. As Debbie reports below, payroll employment rose only 148,000 during December, with private payrolls up 146,000, according to the Bureau of Labor Statistics. That was much weaker than the ADP survey of private payrolls, which showed a gain of 250,000 during the month. The economy is clearly at full employment given that there are roughly 6 million job openings and 6 million unemployed workers (Fig. 11). This suggests that there are skill and geographical mismatches between the people looking for jobs and the available ones.
The most notable mismatch is the expected Phillips curve tradeoff between the unemployment rate and wage inflation. The jobless rate remained at a cyclical low of 4.1% at the end of last year. Yet wage inflation remains subdued around 2.5% (Fig. 12). The core PCED inflation rate is even lower at 1.5% (Fig. 13).
This explains some of Friday’s euphoria in the stock market. What could be more bullish for stocks than solid economic growth with subdued inflation?
Movies. “Molly’s Game” (+ +) and “I, Tonya” (+ +) (link) are two true stories of two very aspirational young ladies. Molly Bloom ran high-stakes poker games in LA and NYC for celebrities as well as scoundrels, many of whom were one and the same persons. She was extremely successful. Her downfall came when the FBI arrested her for racketeering with the expectation that she would rat on her high-stakes clientele, which she refused to do. Hamstrung by her redneck upbringing, Tonya was barred from the respect of the ice skating elite. Yet she was a great skater and could have been an Olympian contender but for her involvement in an attempt to break the kneecaps of her top US competitor.
2018: More Happy Returns?
January 4, 2018 (Thursday)
Strategy: Earnings Driving Stocks Higher. As the new year gets underway, Wall Street’s analysts are calling for S&P 500 earnings to climb 12.3% in 2018, a slight acceleration from 10.9% earnings growth expected for full-year 2017. The energy industry is benefiting from lofty crude oil prices, while other companies are profiting from the continued slide in the dollar and lower tax rates; the retailers and General Electric can look forward to easy comparisons to weak 2017 earnings to boot. Crude oil is up 20% y/y, and the trade-weighted dollar is down 8% y/y (Fig. 1 and Fig. 2).
Here’s what analysts currently are expecting for the S&P 500 sectors’ earnings growth rates in 2018: Energy (41.0%), Materials (18.4), Financials (17.6), Tech (15.3), S&P 500 (12.3), Industrials (9.6), Consumer Discretionary (9.2), Consumer Staples (8.1), Health Care (6.7), Utilities (4.6), Telecom Services (1.2), and Real Estate (-10.2) (Fig. 3).
Earnings estimates often get trimmed as a new year kicks off, but this year they are more likely to be raised thanks to the passage of the tax bill and mounting evidence that the global economy continues to accelerate. Over the past four weeks, forward earnings estimates have been revised upward by 1.6% for the S&P 500. Positive revisions have been even more dramatic in the Energy sector (6.5%), Financials (2.5), Tech (1.9), and Materials (1.7). The only sector that has seen its estimates trimmed is Real Estate (-1.2) (Table 1).
As is the norm, the average sector earnings estimate masks a wide array of earnings growth forecasts for the S&P 500’s industries. The S&P 500 Reinsurance industry is anticipated to have the best earnings growth this year of the industries we track in the S&P 500: a 1,124.6% rebound from the 93.0% drop it incurred in 2017. The industry’s bottom line in 2017 was decimated by losses from hurricanes, fires, and earthquakes.
At the other end of the spectrum, Industrial REITs are forecasted to see a 69.3% drop in earnings, as many properties are at peak levels and loftier interest rates could mean higher financing costs. The earnings drop also occurs because profits from property sales have boosted 2017’s results, but analysts don’t predict what sales will occur in 2018 so they’re not factored into earnings. Let’s dig into the range of earnings outcomes predicted for 2018:
(1) Betting on better weather. Last year, natural disasters made minced meat of the insurance industry’s profits. The only positive outcomes are the easy comparisons the industry will enjoy this year to 2017’s depressed results. The insurance industry’s surge will strengthen the S&P 500 Financials sector—already on strong footing thanks to the earnings strength of banks, brokers, and asset managers that’s expected to continue in the new year.
In addition to a major bounce in the S&P 500’s Reinsurance industry’s earnings, analysts are forecasting a rebound in the Property & Casualty Insurance industry, with earnings expected to rise 52.2% this year after falling 19.3% last year (Fig. 4). The same pattern is expected in the S&P 500 Multi-Sector Holdings industry (BRKB and LUK): 30.9% jump in earnings forecasted for 2018 after earnings fell 9.2% last year (Fig. 5). Earnings growth in the Insurance Brokers industry (AJG, AON, MMC, and WLTW) is expected to accelerate to 16.0% this year from 5.8% in 2017 (Fig. 6). And a second year of good earnings is expected for the Multi-Line Insurance industry (AIG, AIZ, HIG, and L), with 58.0% earnings growth forecasted for this year after 83.6% growth last year (Fig. 7).
The anticipated rebounds in the insurance-related industries should more than offset the slight deceleration projected in some other areas of Financials. Earnings in the Asset Management & Custody Banks is expected to rise 10.8% in 2018 after a 17.6% gain in 2017; likewise, growth should slow for Investment Banking & Brokerage (13.3% this year, 20.7% last year) and Regional Banks (11.3, 19.4), while earnings improve at Consumer Finance (14.6, 3.5) and Diversified Banks (13.9, 9.6).
(2) Gushing profit growth. Energy is by far the sector with the strongest earnings growth prospects. Unfortunately, it currently accounts for only 6.1% of the S&P 500’s market capitalization, so its impact will be limited relative to sectors with larger market caps like Tech (23.8%), Financials (14.8), Health Care (13.9), Consumer Discretionary (12.2), and Industrials (10.2). That said, every bit of good news helps.
The Energy sector has been boosted by the 48.5% jump in the price of Brent crude oil since June 21, 2017. At the current price, Brent is at the high end of the range in which it has traded since late 2014. The market has been helped by the late 2016 deal struck by OPEC members and other major producers to limit production. Then Hurricane Harvey came along last summer and reduced inventories as refiners were shut down during the storm. More recently, the turmoil in Iran has given oil prices a boost.
High US crude inventory levels have been dropping since this summer and are now lower than where they started both 2017 and 2016 (Fig. 8). However, US production has risen in November and December after dipping in October, and now production is well above levels of the past two years (Fig. 9).
Analysts are optimistic about most of the industries in the Energy sector, as it continues to rebound from losses in 2016. The Oil & Gas Exploration & Production industry is forecasted to have 269.2% earnings growth this year, followed by the Oil & Gas Equipment & Services industry (62.1%), Oil & Gas Refining & Marketing (32.8), Integrated Oil & Gas (23.1), and Oil & Gas Storage & Transportation (13.8) (Fig. 10, Fig. 11, Fig. 12, Fig. 13, and Fig. 14). The only industry still reporting losses—albeit sharply smaller ones than it incurred in 2017—is the Oil & Gas Drilling industry.
(3) Tough tech. Given its market cap, one of the most important calls of the year is whether to underweight or overweight the S&P 500 Tech sector. While the overall sector is expected to have respectable earnings growth this year, it’s really some of the insanely fast-growing Tech industries that continue to attract dollars and attention. After growing earnings by 42.1% in 2016 and another 65.7% last year, the Semiconductor Equipment industry is bound for a third year of rapid growth in 2018, with 29.5% projected.
Likewise, the Application Software industry is expected to grow earnings by 24.8% this year, after increases of 21.2% in 2016 and a forecasted 22.8% in 2017 (Fig. 15). Other Tech industries that are expected to grow earnings by more than 20% are Internet Software & Services (21.2%) and Technology Hardware, Storage & Peripherals (22.1).
Valuations: P/Es Upticking. Thanks to strong earnings growth, the S&P 500’s forward P/E inched only modestly higher over the past year despite the market’s strong rally. The S&P 500’s forward P/E stands at 18.5 as of Tuesday’s close, up only a few notches from 17.2 a year ago.
Here’s where all of the S&P 500 sectors’ P/Es stand now and their levels a year ago: Real Estate (39.8 now, 37.8 a year ago), Energy (25.1, 32.4), Consumer Discretionary (21.2, 18.3), Consumer Staples (19.9, 19.3), Industrials (19.5, 17.9), Tech (18.7, 16.6), Materials (18.5, 17.1), S&P 500 (18.5, 17.2), Utilities (17.3, 17.0), Health Care (16.7, 14.4), Financials (14.8, 14.1), and Telecom Services (13.4, 14.2).
(1) Thank Energy. Expansion of the S&P 500 forward P/E remains subdued in part because the S&P 500 Energy sector’s forward P/E is actually lower now than it was a year ago, at 25.1 vs 32.4. That’s because the Energy sector’s earnings, which are rebounding from losses in 2016, are improving faster than Energy stocks are rising.
Excluding the Energy sector, the S&P 500’s forward P/E would be 18.2, up from 16.5 a year ago, according to Joe’s calculations. In other words, were it not for Energy the S&P 500’s forward P/E would have expanded by 9.7% y/y instead of the 7.5% it did (Fig. 16).
The S&P 500 Oil & Gas Exploration & Production industry forward P/E has fallen to 45.6 from 107.2 a year ago. Likewise, the Oil & Gas Equipment & Services industry P/E is 29.3, down from 56.4. The P/E declines in other industries are less significant: Oil & Gas Refining & Marketing (14.4 currently, 14.5 a year ago), Integrated Oil & Gas (22.0, 23.8), and Oil & Gas Storage & Transportation (27.0, 29.8).
(2) Tech rising temperately. Despite its strong run, the S&P 500 Tech sector’s 18.7 P/E isn’t as high as might be expected, and it certainly doesn’t approach the 40-plus P/Es at which the sector traded during the Tech bubble of the late 1990s (Fig. 17). The most expensive industry in the Tech sector currently is Application Software, with a forward P/E of 35.9, up from 32.4 a year ago. While high relative to other industries, the P/E isn’t unjustified if the industry produces the 24.8% earnings growth forecasted for this year.
Along the same lines, Internet Software & Services has a forward P/E of 25.6, but forecasted earnings growth of 21.2%, and Technology Hardware, Storage & Peripherals, home to Apple, has a forward P/E of 13.9 despite the 22.1% growth forecasted for this year.
(3) Blame Amazon. The S&P 500 industry with the highest P/E, Internet & Direct Marketing Retail, resides in the Consumer Discretionary sector even though it counts Amazon and Netflix as constituents. Its forward P/E, at 72.8, has increased significantly over the past year from 52.1. But this industry also has monster growth forecasted for this year: 37.1%.
So while stock prices and forward P/Es have risen over the course of the past year, earnings did too and are expected to continue doing so in 2018. The punchbowl is still on the table.
Drones: Flying High. NBC has a great, relatively new reality show Better Late than Never. This is no Housewives copycat. It features Henry Winkler (famous for his role as The Fonz, Happy Days), William Shatner (Captain Kirk, Star Trek), George Foreman (boxer and grill pitchman), Terry Bradshaw (quarterback, sports commentator), and Jeff Dye (young comedian) having a great time tromping around Europe this year and Asia in 2016. It’s family-friendly entertainment with a bunch of laughs and a little history set in beautiful places around the world.
When the gang was in a park in South Korea, they had a picnic delivered to them by drone. This made us wonder how far the rest of the world has advanced with the technology. Here’s what we found:
(1) Delivering food in Iceland. AHA, Iceland’s largest eCommerce company, is working with Flytrex’s drone system to deliver goods between two parts of the city Reykjavik, which is divided by a river. CEO Maron Kristofersson explains that AHA can save 20 minutes of labor per delivery by sending orders “as the drone flies” instead of paying drivers to circumnavigate the city’s many bays.
(2) Burrito deliveries in Australia. Google affiliate Project Wing is testing a drone delivery service with an Australian Mexican taqueria chain and a drugstore company. The tests are in a rural community near Canberra, where buying most things requires a 40-minute roundtrip, a 10/18 CNN article reported. Goods will be delivered right to homeowners’ backyards.
Success won’t come easily. “The issues range from programming the devices to maneuver safely around obstacles like parked cars or outdoor furniture to following customers' wishes to set down perishable food items close to their kitchens,” the article noted.
(3) Pizza deliveries in New Zealand. Domino’s is experimenting with pizza delivery via drone in New Zealand. “A Domino's customer who requests a drone delivery will receive a notification when their delivery is approaching. After going outside and hitting a button on their smartphone, the drone will lower the food via a tether. Once the package is released, the drone pulls the tether back up and flies back to the Domino's store,” according to an 8/26/16 CNN article.
At the time the article was written, there was a major barrier: New Zealand’s drone rules don’t allow a drone to fly farther than the drone’s operator can see.
(4) Parcel deliveries in China. JD.com had regulatory approval to fly parcels via drones in four provinces over 20 fixed routes at the start of last year, according to a 1/27/17 Recode article, with plans to expand both the number of provinces and routes during 2017.
“We try to deliver with drones from cities to the countryside,” explained JD’s CEO Richard Liu in the article. “In every village, we have a delivery man who lives in the village, and he will take the parcels [delivered by drone] to different houses.” Each drone may carry 8-15 packages ordered in the village.
JD.com isn’t alone. Alibaba has used drones to carry boxes to islands in China’s Fujian province since last fall, according to an 11/9 article on Xinhuanet.com.
(5) Amazon’s in the running too. Amazon has tested drone deliveries in the UK, but it needs regulatory relief to make deliveries in the US possible. The US moved in that direction in October when President Trump “signed an executive order designed to speed the approval of drone flights over crowds and for longer distances. The administration says it wants to open new commercial uses for the aircraft and create jobs,” noted a 10/25 Bloomberg article.
Amazon has filed for a patent for “beehive like towers that would serve as multilevel fulfillment centers for its delivery drones to take off and land. The facilities would be built vertically to blend in with high rises in urban areas. Amazon envisions each city would have one,” a 6/23 CNN article explained. “The towers could support traditional truck deliveries and include a self-service area where customers can pick up items, the patent states. It also details how employees would attach the packages on drones.”
Soon, we may never need to leave our homes again.
Happy New Year!
January 3, 2018 (Wednesday)
Welcome Back. I hope you had a great holiday season with your families and friends. My family and I spent 10 days in Southeast Asia. We started by dodging mopeds in Hanoi. Then we took a two-day cruise in Hai Long Bay, Vietnam followed by sightseeing in Siem Reap, Cambodia, and a couple of days on the beach in Krabe, Thailand, which looks just like Hai Long Bay. We stopped off in Bangkok on the way back home. It was a long way to go, but very worthwhile.
We didn’t run into very many American tourists, but Chinese tourists were everywhere. My number-one investment idea for the New Year is to invest in any company that benefits from Chinese tourism. The numerous ancient ruins of palaces and temples indicated how much was spent by Asian kings (like all kings) on such extravagances. Today’s Asian governments are pouring money into infrastructure and shopping malls.
As Sandy Ward reviewed in our 12/19 Morning Briefing, Southeast Asia’s major economies are booming. The Vietnam MSCI stock price index soared 60.7% in local currency and 61.2% in dollars last year (Fig. 1). The Emerging Markets Asia MSCI stock price index jumped 33.3% in local currencies and 40.1% in US dollars during 2017 (Fig. 2).
During 2016, the region benefited from a global synchronized recovery from the energy-led growth recession of 2015. During 2017, that recovery turned into a global synchronized boom, which is likely to continue in 2018. Contributing to the global economic boom is solid growth in the US. Consider the following:
(1) US trade is solid. The sum of US real exports and real imports rose to a record high in October (Fig. 3). The yearly percent change in this series is highly correlated with the comparable growth rate in the volume of world exports (Fig. 4). The former was up 4.4% through October, while the latter rose 3.9% over the same period. These growth rates were both around zero in early 2016.
(2) Surprise index is surprisingly strong. The Citigroup Economic Surprise Index closed 2017 at a reading of 75.7, a remarkable recovery from the year’s low of -78.6 on June 16 (Fig. 5). This index (along with US GDP) has tended to be weak at the start of every year since 2011 and then to rebound later in the year. If the global economy and US economies really are booming, then the index shouldn’t weaken much at the start of the current year.
(3) Housing may finally be recovering. During November, new home sales jumped 17.5% m/m and 26.6% y/y to 733,000 units (saar), the highest pace since July 2007 (Fig. 6). Nevertheless, this pace remains closer to this series’ previous cyclical lows than its previous cyclical peaks. This implies that there is more upside if home buying really is finally taking off. Lumber prices soared at the end of last year as single-family building permits rose during November to 865,000 units (saar), the highest since August 2007 (Fig. 7 and Fig. 8). Existing home sales jumped to 5.81 million units (saar) during November, the best reading since December 2006.
(4) Transportation indicators off the charts. The ATA trucking index soared 2.3% m/m and 7.6% y/y during November (Fig. 9). Intermodal railcar loadings also rose to record highs at the end of last year, as the sum of outbound and inbound West Coast port container traffic did the same (Fig. 10).
(5) M-PMIs flashing bright green. The US M-PMI rose from 53.9 during November to 55.1 during December, the best reading in 33 months. Overseas, the M-PMI for the Eurozone rose to 60.6, its best level since the survey began in mid-1997! Japan’s M-PMI flash estimate rose to a 46-month high of 54.2 last month. (Japan’s final estimate will be released on January 4.)
US Taxes I: Too Stimulative? In the past, Congress often has cut taxes to revive economic growth following a recession. Last year’s tax cut came long after the last recession and despite clear signs that the US economy is strong. This potentially raises the risk of a typical boom-bust scenario. If so, then it’s quite possible that the economy will heat up, with real GDP closer to 3% than 2% and inflation moving higher. Debbie and I won’t be surprised to see higher growth, but we still believe that global competition, technological innovations, and aging demographics will keep a lid on inflation. If so, then productivity could make a long-awaited comeback.
For the stock market, this scenario provides more support for our meltup-meltdown scenario. Joe and I continue to assign subjective probabilities of 55% that stocks will melt up, 20% that stocks will march higher at a moderate pace in line with earnings, and 25% that stocks will melt down. Notably, these are not independent scenarios, since the latter one depends on whether the first scenario unfolds.
The tax cuts enacted at the end of last year are likely to push stocks higher as investors anticipate that corporate earnings will be significantly boosted as a result. Joe and I are forecasting that the Trump administration’s tax cuts and deregulatory actions will boost S&P 500 earnings this year by $6 per share to $147, up 11.8% from last year. Also driving stock prices higher should be significant repatriation of foreign earnings, boosting share buybacks and dividends.
So what could go wrong? Bond yields could jump as the Fed continues to normalize monetary policy, possibly faster than widely expected. Now let’s turn to how the tax cuts might affect earnings and buybacks.
US Taxes II: Deferred Tax Assets & Earnings. Tech companies took big earnings hits after the tech bubble burst in 2000. Financial services companies took huge hits during 2008. But on the plus side, many firms in both sectors converted their losses into “deferred tax assets,” using the accumulated losses to reduce their reported earnings when they turned profitable again. The bad news is that now those assets are worth much less after Congress lowered the statutory corporate tax rate from 35% to 21%. The good news is that affected companies will take one-time charge-offs and enjoy a lower corporate tax rate.
During the late 1980s and through the 1990s, the NIPA data (i.e., the National Income and Product Accounts data that the Bureau of Economic Analysis uses to calculate GDP) showed that the global effective tax rate (G-ETR)—which includes taxes paid to the IRS as well as other domestic and foreign taxing authorities—was quite close to the IRS statutory tax rate (IRS-STR) (Fig. 11). During 1999, the G-ETR was 34.1%, about the same as the 35.0% IRS-STR. The tech wreck caused the effective rate to plunge to around 25% during 2002-2007. Then the financial crisis of 2008 pushed the effective rate down to around 20% from 2008-2017.
Previously, Melissa and I have observed that the NIPA corporate profits and taxes paid data include the profits earned and taxes paid by the Federal Reserve. Both rose sharply as a result of the “profits” earned by the Fed on its mounting QE assets (Fig. 12). Removing the Fed from the numerator and denominator of the G-ETR calculation doesn’t change the basic story other than to show an even lower global effective tax rate (Fig. 13).
Now corporations will have fewer deferred losses but also a lower IRS-STR. Melissa and I aren’t sure how this will all add up for S&P 500 operating earnings. Presumably, pre-Trump reported earnings and taxes were held down by the deferred tax losses. We can’t quantify it for the S&P 500, but we suspect that deferred losses were excluded from operating earnings, which are often referred to as “EBBS,” i.e., “earnings before bad stuff.” The hits to deferred tax assets most likely will be treated as one-time charges this year, which means that they won’t depress operating earnings.
In the short term, this implies a wash for the tax impact on operating earnings. Instead of paying a 20% G-ETR, with the help of deferred losses, they’ll be paying a 21% statutory rate on US income. So why are Joe and I adding $6 per share to S&P 500 earnings this year? Chalk it up to “animal spirits” as Trump’s pro-business policies boost earnings growth. Besides, lots of companies and industries don’t have enough in deferred assets to rack up significant tax savings.
US Taxes III: Overseas Cash Stash & the Meltup. On Friday 12/29, the IRS and Treasury issued new regulations on the taxation of foreign profits. Bloomberg reported: “The tax-overhaul bill signed last week by President Donald Trump requires companies to pay taxes on those earnings at two discounted rates—15.5 percent on income held as cash and cash equivalents and 8 percent for illiquid assets. Those rates apply to an estimated $3.1 trillion in earnings stockpiled overseas since 1986.” Previously, repatriated earnings were taxed at 35%, though companies were allowed to defer paying taxes on foreign earnings until they were brought back to the US.
The Fed’s Financial Accounts of the United States includes a series for “foreign earnings retained abroad” by nonfinancial corporations (NFCs) (Fig. 14). It is shown as an annualized quarterly flow. The level is not available. It isn’t insignificant, but it is a relatively small percentage of NFCs’ pretax profits (Fig. 15). However, on a cumulative basis, it totals $3.5 trillion since 1986 (Fig. 16). The Bloomberg article mentions “an estimated $3.1 trillion in earnings stockpiled overseas since 1986.” If much of that gets repatriated, the result could be a meltup in the stock market and a boom in the US, followed by a meltdown in stocks and possibly a bust for the economy.
US Taxes IV: More Taxing Math. Melissa and I continue to tinker with the macro corporate tax data for clues to the likely impact of the tax cut on corporate taxes. The conclusion we keep coming up with is that it isn’t all that significant, running around 20% since 2000. Above, we discussed the “wash effect” on operating earnings between the tax rates with and without deferred tax assets. Now let’s look at how much taxes paid overseas amounts to. The surprise is that it’s not much, which is consistent with the Fed’s data showing that NFCs’ profits retained abroad have accounted for about 20% of total profits since 2000. Consider the following:
(1) At the end of last year, we sought to compare the NIPA data on taxes paid by corporations to the IRS data. The former is global, including taxes paid to the IRS as well as other domestic and foreign entities. Subtracting the “taxes” paid by the Fed and taxes paid to state and local governments should yield a series reflecting corporate taxes paid to the IRS and foreign taxing authorities (Fig. 17).
(2) Now let’s subtract from this derived series the amount of corporate taxes paid to the IRS. The result is a surprisingly small number for what should be taxes collected overseas from US corporations (Fig. 18). Over the past four quarters through Q3, the residual was $50 billion ($347 billion minus $297 billion), presumably collected by foreign taxing authorities.
This implies either that US corporations collectively aren’t doing as much business overseas as they are domestically or that they are paying very low tax rates overseas, or both. Whichever the case, the fact remains that the US corporate tax rate now is more important in determining their after-tax profits.
(3) Accounting for corporate taxes at the macro level gets even messier when we consider that the profits of S corporations are included in NIPA pretax profits, but their profits get taxed by the IRS as individuals when the owners pay themselves dividends. We do have data on dividends paid by S corporations. However, these data can’t be used as a proxy for their profits since there are plenty of money-losing S corporations that aren’t paying dividends. So we probably have hit a dead end regarding a macro analysis of the effective corporate tax rate. We may have gone as far as we can trying to analyze corporate taxes at the macro level.
Movie. “All the Money in the World” (+ +) (link) is a docudrama about the kidnapping of 16-year-old John Paul Getty III in Italy during 1973 and his mother’s desperate struggle to convince his billionaire grandfather, J. Paul Getty, to pay the ransom. At first, he refused to pay, arguing that complying would increase the chances that his 14 other grandchildren would be kidnapped too. He relented after the kidnappers sent an envelope with the boy’s ear. However, the skinflint negotiated a deal to get his grandson back for about $2.9 million. He paid $2.2 million—the maximum amount that was tax deductible—and he loaned the remainder to his son, who was held responsible for repaying the sum at 4% interest.