Tuesday, May 16, 2017

Stocks are expensive under normal times - these are not normal times.

I make it a point to watch the news every evening at 6:00 p.m., even though it is quite difficult to wrestle the T.V. remote away from my beloved daughter and her cartoons. Often times after watching the news I scratch my head to understand exactly what they are discussing and why. Clearly, these viewers of the nightly news are not seeing the positive economic benefits that can be found everywhere. I also read the headlines on Yahoo on a daily basis and think, “What cave do these writers live in?” The economic news is so overwhelmingly positive at the current time that it should be difficult for any writer not to see the clear and convincing positive economic tea leaves.

I will deal with some of the issues that the opening paragraph contemplates later, but first let me report the extraordinarily good news of the stock market. For the month of April, the Standard and Poor’s Index of 500 Stocks was up a nice 1%. Year-to-date, it is up 7.2% and for the one-year ended, it is up 17.9%. And by the way, that is the worst performing index of the major U.S. indexes. The NASDAQ Composite was up 2.9% in April, 12.7% year-to-date and 28.2% for the one-year period then ended. The Dow Jones Industrial Average was up 1.5% in April, 6.7% year-to-date and up 20.9% for the one-year period ended April 30, 2017. Just to give you a basis of comparison, the Barclays Aggregate Bond Index was up 0.7% for April, up 1.5% for 2017 so far and has a one-year total performance of 0.5%. Notice I did not say 5%, I said one half of 1%, or 0.5%, for the one-year period then ended. How anyone could make a positive recommendation for bonds in this environment and keep a straight face is quite beyond my ability of comprehension.

From a personal standpoint, I have been very busy this year with tax season and other matters. The first weekend in May was quite an extraordinary time. My son, Joshua, graduated from Auburn University with honors from their business school – maybe one day he will work here. Simultaneously, my daughter, Ava, graduated from kindergarten. Yes, I know there is a big difference between age 22 and age 5. However, both were significant and certainly events to be celebrated. Josh is now moving on to graduate school at Auburn while Ava ventures into the excitement of her first year in real school. It is an exciting time for everyone. Congratulations to both for a job well done!

Josh and Ava

Dakota, Ava, Josh and Joe

Danielle, Robby, Joe and Eddie
Partners at Rollins

I would like to cover some of the positive economic events and go over some items that you may have missed due to all of the negative headlines that confront us every day. As the headline of this posting indicates, no one could argue that stocks are cheap today by historic standards. Prices today are roughly 21 times earnings, which is not terrible if you compare that with the average of 19.2 over the last 25 years. Certainly, not outrageously expensive, but certainly not cheap. However, those numbers do not explain why stocks continue to climb. With the low interest rates that we enjoy today, even Warren Buffet comments, “Measured against interest rates, stocks are on the cheap side compared to historic valuations.” Basically, this statement is a firm grasp on the obvious. If you can only get zero interest in your money market account, but a vanilla index such as the S&P 500 generates a dividend return of 2.2%, why would you ever invest in cash? Basically, that is what the richest man in the world is questioning. I question it every day and in return I get blank stares from potential investors who do not find it as obvious.

Some of the following items are clearly controlling the upward trend in the markets. Have you even for a second considered the potential of the economic benefits of repatriation of foreign earnings to the U.S. For reasons too technical to explore in this short article, U.S. corporations that earn profits overseas are not taxed on those profits until they are brought back to the United States. At the current time, to do so would create a 35% tax, which is prohibitive and therefore those profits are not being brought back home. Under the proposed bill to reform income taxes in Congress, there would be a special rate of 10% to encourage U.S. companies to bring those profits back to the U.S.

It is now believed that roughly $2 - $3 trillion (not billions, but trillions) are parked in overseas accounts that would be tempted to be repatriated. Let us assume that $2.5 trillion is repatriated back to the United States, generating a cool tax bonus of $250 billion (a 10% tax rather than the current 35%). If you want to know the way that the infrastructure in the U.S. could be reformed, there it is in one sentence. A tax of $250 billion specially allocated to major interstates, bridges, airports, naval ports, airline software, navigation and upgrades. Can you even envision how many U.S. workers could be employed under this one simple provision mentioned above?

That is the obvious solution to many of the problems with infrastructure, but think about what happens to that repatriated money. U.S. corporations would be encouraged to make acquisitions at improving stock prices, paying dividends to shareholders, buying back stock, etc. Each and every one of these actions would create higher income taxes to the Treasury, thus improving the deficit. If the U.S. based companies were to bring back this cash to the United States, pay an appropriate amount of tax and then use that money to expand their businesses, virtually every aspect of the U.S. economy would be improved. This is one of the reasons that the stock market climbs in the face of the overwhelming negative news that surrounds us every day. Maybe “fake” news.

The economic news for the month of April continues to be good. The U.S. economy produced 211,000 jobs during the month of April and the unemployment rate was down to 4.4%. As I have often relayed in these postings, when I was in college, they taught us that 5% unemployment was considered full employment. Today, the unemployment rate is significantly below that 5% level at 4.4%. I know many employers seeking current employees that post jobs and are getting zero responses. It has been a long time since I have personally seen excess jobs with not enough people to fill those jobs. That is a great sign for the economy. So much of the negative news on unemployment has been focused on the U6 unemployment rate. For the technically challenged, that means underemployed. Even that fell to a post-crisis low of 8.6%. You may recall that in the height of the 2007-2008 recession, that rate was a stunning 16%. Over the last one-year period, there have been 3 million new jobs created, putting these people to work, along with their families, relatives and local merchants. The economic news on unemployment could not have been better.

Most of the largest companies in America have finished reporting earnings for the first quarter of 2017. At the current time, it now appears that the first quarter profits of 2017 will be higher than the first quarter profits of 2016 by a very impressive double digit increase. My statement above regarding the prices of stocks being somewhat higher than the historic average of the last 25 years does not contemplate a double digit increase in earnings as we go forward. That is past earnings, not future earnings. If you build into your models an increase in corporate earnings by double digits, by any historic standard, stocks are cheap.

But the best economic news I will save for last. It is my opinion that the news of the upcoming tax reductions will have an economic effect only matched once before in this country. If you think earnings of U.S. corporations are good now, factor in an income tax rate decrease from 35% to 15% and you will see corporate earnings explode upward. How could the stock market ignore the potential for overnight corporate America to receive a benefit to their bottom lines by reducing corporate tax rates? If you modeled in a 10% increase in earnings as mentioned above plus an almost 50% cut in income taxes, all of a sudden, the price to earnings ratio of corporate America is no longer 21, but 15 – much below historic standards!

We should also put to rest any doubt that the economic theory of bigger government and higher taxes practiced over the last eight years is dead and the economic proof is not only overwhelming, but resounding. Economic growth over the last eight-year period was an astonishing low 1.47%. In all the other recoveries from recession, the economic growth has been 3.4%. There are many that believe that this low growth was exaggerated by higher income taxes forced on the economy, a much higher level of administrative oversight and an astonishing lack of economic stimulus during this eight-year period. You may recall that tax rates were increased dramatically under the Obama years. Federal revenues were supposed to rise by $650 billion over the following decade because of the 2013 tax increase; however, that was not an accurate forecast. Revenues are now projected to fall by almost five times that amount because economic growth continues to falter. Therefore, in everyday terms, it is the consensus of most that if you increase taxes, federal revenue should grow but in reality, an increase in taxes draws down growth. Rather than an increase in revenues to the Treasury, it actually falls.

Go back to the years preceding Ronald Reagan’s presidency. From the period 1974 through 1980, GDP growth was 2.5%. Clearly, the country was in recession and inflation was high when President Reagan took office in 1981. However, one of his first moves was to cut marginal tax rates, increase defense and cut entitlement spending and reduce the regulatory burden. I am unsure whether or not you have noticed, but this is the exact strategy that President Trump is following. Once those policies were in place, economic growth averaged 4.6% during the remainder of his presidency. More importantly, federal revenues grew at double digit rates during four of his last six years in office. Now compare the economic record of the Reagan years with the economic record of the Obama years.

So, the biggest economic news going forward is the potential that economic growth would make up for the reduced rates, and therefore whittle away at the current huge deficit. But there is also unbelievably good news regarding employment in the U.S. President Trump’s attempts at creating better trading patterns with the rest of the world have already shown fabulous economic benefits. Countries around the world are now spending money in the U.S. to manufacture as well as employ U.S. workers. If you gave them the 15% tax rate in the U.S., you would see an overwhelming flood of foreign companies creating jobs in the United States. You would also see U.S. companies bringing manufacturing back to enjoy this 15% rate. Good times are coming – watch and see.

We talk daily about a so-called border tax, but no border tax would be needed if we had fair economic policies around the world. As an example, virtually all of the shrimp sold in the United States is imported from China, Indonesia and their bordering countries. They import that shrimp at virtually no import tax. However, U.S. fisheries cannot export into China without a 30% tax. If you equalize those rates, economic expansion will occur on both sides.

Over the weekend, China announced that once again, U.S. manufacturers can ship meat into China. If you do not realize that concession by China was not of their making, you do not understand economic pressures that the U.S. can have on the rest of the world. We all believe in free trade, but it has to be fair trade. I think the current president has proven that if you threaten foreign countries with no free trade, but equal trade, they will manufacture in America rather than in their own countries. The economic growth of the U.S. drives the economies of the world, since they all export to America. If you have equal trade, it would be much more beneficial for them to produce here than at home.

As I sit and watch the endless debates on totally irrelevant subjects by Congress, I wonder who understands this nonsense. Other than politicians, who really cares who the FBI director is? Who really cares about who insulted who? What I care about are economic results and they are happening at the current time. If legislative policy follows the predictions made herein, now may be the finest buying opportunity in equities that we have seen in our lifetime. Yes, I understand that is a bold statement. However, if you are not invested, you will never benefit.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins