Measured Ascent

Measured ascent.  Stocks took a break yesterday, pulling back, after rushing to fresh highs on Monday.  The IMF scaled up its global growth forecast on easy monetary policy, greater fiscal support, and more vaccine, but warned that not all countries will rise at the same pace.

N O T E W O R T H Y

The butcher’s bill.  Imagine a giant production facility, windows blacked out, fluorescent lights flickering, and thousands of machines all humming in unison. You look closely at the machines, which are spitting out large sheets of $100 bills so fast that you can barely make out the sheer numbers and work out the calculations.  “Ah”, you think,“ so this is where they print all the money to make up for budget shortfalls.”  If you think that, you are not alone, but I am sorry to tell you that is not exactly how it happens.  A country has what is known as a fiscal balance.  That is a reckoning of all of the country’s incoming funds and outgoing funds.  Sound familiar?  It should, because it is a lot like yours and my checkbooks.  In order to remain in good legal and credit standing, we must make sure not to write checks whose total exceeds our balances.  Ok, hopefully you knew that.  A government however is not under the same constraints as you and I. A government’s primary source of income is taxation and it utilizes those taxes to pay for all of the services it provides to its citizens. If a government spends more than it takes in, it is operating on a fiscal deficit.  That deficit can only be avoided by either spending less or raising taxes. Taking away services from citizens is never popular, and raising taxes… well, you know. The solution to the deficit is: credit.  Governments borrow money in order to make up budget shortfalls.  I don’t want to get into the history of the deficit in the US as I have covered it multiple times in my notes, but spending has been very much in the news over the past year, as you might guess.  Three stimulus packages have come and gone and a new infrastructure deal is in the works.  Now there are all sorts of debates, both political and economic, on whether deficits are acceptable or deplorable.  Other than the fact that we were all taught to never exceed our budget, there is truly no good argument on either side.  Let’s leave those debates to the politicians and economists.  What does it mean for us as investors? For stocks, there may be some implications.  The Tax Cut and Jobs Act of 2017 reduced the statutory corporate tax rate from 35% to 21%.  In theory, companies gained an additional 14% in net income as a result of the tax cut.  That increase in income should, technically speaking, increase the value of a stock.  If you are using multiples, the calculation is straight forward. The E (EPS) in the PE multiple increases, and if we keep that PE multiple constant, a stock’s P (Price) is cheap, and should increase.  If you are using cash flow discounts to come up with a stock’s value, lower tax bills mean more cash flow in the future, which translate into a greater present value, or intrinsic share value, today.  Trust me on the math.  So, lower taxes should be good for stocks, all other things kept equal, and they have been, though the tax cuts may not be the sole source of the rise. Lawmakers like to talk about how corporations utilize the excess cash from the tax cuts to hire more employees and invest in capital improvements, both stimulative for the economy.  In practice however, many companies used the additional cash to facilitate stock buybacks and dividends.  While there is nothing morally or legally wrong with that, the funds ultimately ended up benefiting stock holders far more than the overall economy.  So, the net net (Wall Street slang for bottom line) is that tax cuts are good for stock prices.  Last week President Biden announced his $2 trillion infrastructure plan, which would be partially subsidized by… you guessed it corporate tax hikes. He specifically referenced the raising of statutory rates from 21% to 28%.  Though there were no specifics, the Administration also plans to propose income tax hikes for higher income earners ($400k+) at some point in the future as well.  Let’s focus on the corporate tax rates for this discussion.  If approved, corporations would have, using the same basic math from above, 7% less cash or earnings. Theoretically speaking, again using the same math from above, tax hikes should have a negative effect on stock prices.  Though the tax hike, which would be the first hike since 1993, is not likely to affect dividends, it certainly could have an impact on the magnitude of buybacks.  So, will stocks actually go down as a result of a corporate tax hike? Answering that definitively would be pure speculation, because on Wall Street a stock’s price is, literally, a stock’s price and the theoretical math is usually trued up to it.  I will leave you with some facts, however.  First, I was careful to use the term “statutory tax rate” above.  That is the tax rate imposed by policy.  If we look at the effective corporate tax rate, we see a different picture.  The effective tax rate is what corporations actually pay after deductions, special credits, and legal loopholes, and that number is considerably lower than the legal tax rate.  While many experts agree that the 35% statutory rate prior to the ’17 tax act was too high compared to other nations, they also believe that moving them slightly higher is likely to have a minimal effect on effective tax rates.  Of course, every company is different, and taxes affect the various industries in a different manner, but for the most part there is not likely to be a 1 to 1 impact.  So, that may be positive news for stocks, but what about the fiscal budget?  Well, now that you know that there isn’t some mysterious basement printing facility, you would be correct to assume that shortfall is likely to be met by an increase in government debt.  

THE MARKETS

Stocks slipped in yesterday’s session, resting after posting a big rally on Monday in response to Friday’s blowout jobs number. 

The S&P500 fell by -0.10%, the Dow Jones Industrial Average dropped by -0.29%, the Russell 2000 Index gave up -0.29%, and the Nasdaq Composite Index slipped by -0.05%.  Bonds advanced and 10-year treasury yields pulled back by -5 basis points to 1.65% helping growth stocks gain on the day.

NXT UP

– FOMC meeting minutes (March 17) will be released this afternoon. While the Fed has staunchly protected its current policy of easy money and bond purchases, traders hope to gain some information on when those policies may change and what those changes may entail.

– EIA Crude Oil Inventories (April 2) are expected to have declined by -1.638 million barrels after falling by -863k in the prior week.

– Fed speakers include Evans, Kaplan, Barkin, and Daly.