Are tax cuts already priced in U.S. stocks?

Many stock market pundits have conflicting opinions as to how much of the tax cuts are baked into current stock prices. Some experts believe that a selloff in the stock market will occur in January as money managers rotate out of technology and into other sectors that will benefit the most from tax reform.

Their rational is tech companies were in a low tax environment before tax reform was passed and it is better to take profits when lower personal tax rates take effect in 2018.

In comparison, sectors like transportation, telecom, retailing and banking have high tax rates. In addition, the new tax bill also offers substantial write offs for new capital expenditures. Industrials, energy as well as telecom companies require large capital expenditures in order to grow their businesses. However, it is difficult to predict if and when these expenditures will occur.

“In a special report to clients, Barclays Capital analyst Maneesh Deshpande and team calculate that the benefit is less than it appears: While the statutory corporate tax rate is set to fall from 35 percent to 21 percent, the effective rate for S&P 500 companies (the rate companies actually pay after all the accounting trickery) is set to fall from 26 percent to 20.7 percent.”

On the other hand, some market watchers believe that tech companies should still be in your portfolio. There is still room to run higher because they have an opportunity to take advantage of the repatriation tax holiday which reduces the tax rate from 35% to 15.5%. The top 5 U.S. tech companies that have cash overseas:

  1. Apple – 230 billion
  2. Microsoft – 113 billion
  3. Cisco – 62 billion
  4. Oracle – 52 billion
  5. Google – 49 billion

Although, the last repatriation tax holiday was at a much lower tax rate. The money was mostly given back to shareholders in the form of higher dividend payments and share buybacks.  Should you invest hoping for history to repeat itself?

Secretary of the Treasury, Steven Mnuchin said:

“There is no question that the rally in the stock market has baked into it reasonably high expectations of us getting tax cuts and tax reform done.”

I tend to agree that a large portion of tax cuts are already priced in most U.S. stocks. For example: Charles Schwab (SCHW, $52.04) has had enough of the tax man. The online stock broker and banker has paid out a stunning 37% of its income in taxes over the course of the past five years, versus a rate in the mid-20% range for most other American companies. It was trading around $45.00 in Nov and it is up $7.00 or 15.5% in just a few short weeks.

The chart below contains the one year return for tech (xlk), financials (xlf), industtials (xli) and energy (xle):

Three of those sectors have already had above average returns for 2017. The energy sector has lagged but tax reform alone will not be enough to propel the energy sector higher. The price of oil is still the main factor in increasing the value of oil stocks.

Another factor to consider is the labor market is extremely tight and the post-recession surplus of economic potential may have run out. The tax reform bill may end up boosting inflation by more than it lifts economic growth encouraging the Fed to be more aggressive with interest rate hikes in 2018.

I am cautious optimistic that U.S. stock market returns will be positive in 2018. I believe that volatility will come back next year and offer some good buying opportunities. It could turn out to be a stock pickers market.

Are you buying the dips or selling the rallies?

 

 

 

 

 

 

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Home bias adds sector risks for investors

 

 

 

 

 

 

 

Legendary investor Warren Buffett, among others, is notorious for telling investors to buy what they know. Basically, Buffett and his enthusiastic followers suggest investing in companies that you really understand or at least know enough about them to be able to explain how they make money.

That is fairly good advice if you are an American since the S&P 500 generates nearly half of its revenue from outside of the United States. However, there is still a lot of risk in the form of sector concentration. For example, the tech sector accounts for nearly 21% within the S&P 500.  Do you remember the bursting of the dot com bubble?

Home bias for Canadian investors is really risky. Seventy–five percent of the Toronto stock market is dominated by three sectors, energy, materials and financials. There are only a handful of companies in other sectors that are available to further diversify your portfolio. Year to date, the Toronto stock exchange is only up 5% compared to the S&P 500 which is up 18.5%, see chart below:

The Canadian market has under-performed when compared to the U.S. markets for the past five years. The main reason is the decline in oil prices which has effected many non-energy sector companies which still rely energy prices in determining their revenue growth. For instance, Canadian banks may rely on loans to energy companies to drive their growth rates. See the 5 year performance chart below:

Why home bias exists

Vanguard’s Investment Strategy Group identified a range of reasons why investors might not embrace global diversification, including concerns about currency risk and an expectation that their home country will deliver out sized returns.

One factor we identified—preference for the familiar—seems particularly relevant. With so much global uncertainty about geopolitics, monetary policy, and the economic outlook, it’s understandable why investors may not want to stray too far from home.

Why Canadian markets may continue to under perform the U.S.

  • Oil and gas exports are land locked and selling at a huge discount!
  • The housing market is slowing down due to a 15% foreign buyers tax, tightening mortgage rules and higher mortgage rates.
  • Tariffs on softwood lumber and airplanes from our largest trading partner (U.S.) has put the success of re-negotiating NAFTA questionable.
  • Passing of the U.S. tax reform legislation will make investing in Canada less attractive (plus we have a carbon tax and high electricity rates).
  • Canadian consumers are carrying high levels of debt which will slow down spending.

Exchange traded funds are a low cost way to diversify your portfolio outside of North America. Many providers offer the ability to hedge fluctuations in foreign currencies. 

The markets are due for a correction, I would recommend slowly increasing your exposure to the U.S. stock market.