Last week, U.S. stocks rose on reports that the new administration might lower corporate tax rates. I suppose that’s as good a reason to rally as any. Our corporate tax rates are fairly high by international standards, and every dollar paid in taxes is one that can’t be reinvested in the business or paid out to shareholders in some form.
Still, I am not sure that the upcoming tax announcement was the only or even the key reason for the market’s ebullience over the last three months. Stated corporate tax rates may be high, but there are already plenty of perfectly legitimate methods to keep the effective cash tax rate at lower levels. To me, this is just part of a shift in Washington’s attitude toward Wall Street. The new administration may be pro-consumer, but that might be translated as pro-growth. That could be seen as a general trend towards lower taxes, fewer regulations, and fewer restrictions. That would likely not be bad for either profits or multiples.
Besides, forward earnings expectations seem to be rising again after two years of stagnation (particularly for small and mid-cap stocks). I think that rising expectations are moving stocks higher and could possibly have a “double whammy” on stock prices. First, higher earnings could bring higher stock prices, even without a change of the price-to-earnings multiple. More importantly, however, is the positive effect that a resurgence in profit growth could have on multiples.
Rising profits could give lie to the notion that we are near the peak of both the economic and profit cycle. Traditional valuation methods are tricky things because they have so many moving parts. Interest rates, corporate spreads, quality of earnings, perceived growth rates, and a risk premium are all part of the equation. If the valuation model gets just one wrong, it spits out the wrong answer.
However, for economically sensitive stocks in particular, there is something else: Where are we in the economic cycle? The market knows that earnings can be tidal and often pays more for a dollar in earnings near the beginning of a cycle than it will for a dollar in earnings toward the end of that cycle. It would seem that a change in the perception of the cycle’s longevity could and should have a change in what investors perceive as fair valuation. Usually, in the latter stages of a bull market, this reevaluation is what happens. Intimations of impending economic mortality lessen and investors respond with buy tickets.
I think that is beginning to happen now. More robust earnings growth could change our perception of the duration of the economic cycle and pull us into stocks. After all, that’s what a pull bull market is all about.