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.

A big disconnect between the Stock Market and the Canadian Economy

Canada’s economy is expanding at its fastest annualized rate in six years according to Statistics Canada. That’s a quarterly expansion rate of 4.5% which is the highest figure since the third quarter of 2011. It was led by the biggest binge in household spending since before the 2008-2009 global recession.

Economists had predicted Canada to grow around 3.7% and the Bank of Canada latest forecast was for GDP to expand at 3% in their July press release. When combined with the 3.7% expansion of the first quarter, it’s the strongest six month start in 15 years.

Why isn’t money pouring into the Toronto Stock Market?

Often times the equity market is moving well before the economy does and of course the Canadian equity market had a robust year in 2016. Investors may already have priced in all the good news last year, when Canada’s stock index gained 18 percent, one of the world’s best performances.

Part of the problem is that Canada’s stock market isn’t totally reflective of the economy, since it’s heavily reliant on energy and financials. Those two sectors account for 54 percent of the S&P/TSX Composite Index.

The outlook for oil is very subdued, it is still trading below $50 a barrel even with the shutdown of refineries due to hurricane Harvey. Global inventories continue to stay high and OPEC’s has lost its influence in cutting production. Crude oil prices in the future’s market are still below $50 a barrel for all of 2018 and part of 2019. Foreign investors are taking money out of the Alberta’s oil patch.

Continued growth in residential investments which was up an annualized 16 percent in the first quarter is also likely to fade as the impact of government measures to cool housing markets kick in. Although, bank earnings have beat expectations by a wide margin, loan growth going forward is expected to decline and loan losses are expected to increase. U.S. hedge funds are still shorting Canadian financials expecting the housing bubble to burst.

Investors believe that this robust growth will force the Bank of Canada to continue raising interest rates this year. It could add extra pressure to lowering consumer spending due to high indebtedness of Canadian households. It will also add a cooling effect to the hot housing prices in both the Vancouver and Toronto real estate markets. The rapid rise in the value of the Canadian dollar is added proof that currency traders are betting that a hike in interest rates is coming soon.

Uncertainty over NATFA  renegotiation

Global political developments aren’t helping, with renegotiation of the North American Free Trade Agreement which started in August, created a new spat with the U.S. erupting over aerospace manufacturing.

Already, data suggest investment into the country is cooling. Foreign direct investment in Canada dropped 25 percent to C$8.68 billion in the first quarter, according to separate data released Tuesday. The country relies heavily on foreign funding to finance spending — totaling C$130 billion over the past two years, according to balance of payment data.

Canada has benefited from a convergence of developments that include a coordinated global recovery and rising trade volumes. The bottoming of the oil shock in western Canada, along with federal deficit spending, rising industrial production in developed economies. Canadian consumers have benefited from a buoyant jobs market and rising home values, resulting in a surge in consumer spending.

Is this Sustainable? I think not!

Economists had been predicting a slowdown in growth to about 2 percent in the second half of this year, but are revising numbers up after the GDP report. I believe this surge in economic growth is temporary. The higher value of the Canadian dollar and higher interest rates will dampen economic growth.

The Toronto stock market returns for all of 2017 are flat which could indicate that foreign investors also believe the future going forward isn’t so rosy!

 

 

 

Warning signs that oil prices are range bound for many years

The future price of crude oil is very important to the Canadian economy and to investors in the Toronto stock market (TSX). The Canadian oil patch represents a 25% weighting in the overall index. Over the past few months, we have seen a massive sell-off of oil sands assets by foreigners.

In March, Royal Dutch Shell and Marathon Oil sold stakes in the Alberta oil sands project to Canadian Natural Resources for $12.7 billion. Marathon sold its 20% stake in the project for $2.5 billion. Later in March, Conoco Phillips sold their partnership in the oil sands to Cenovus Energy for $17.7 billion.

Reuters reported last week that BP is considering the sale of its stakes in three Canadian oil sands projects.

“BP’s 50 per cent stake in the Sunrise project near Fort McMurray in Alberta, where Husky Energy Inc owns the rest and is the operator, is the most valuable of the three assets. It also owns a 50 percent stake in Pike, operated by Devon Energy Corp, which is still awaiting a final investment decision, and is majority-owner of the Terre de Grace oil sands pilot project.”

Also in the news is Chevron was exploring the sale of its 20% stake in Canada’s Athabasca oil sands project which could fetch $2.5 billion.

“Faced with a lower oil price environment and challenging economics, which include high cost operations and carbon taxes, global players are increasingly put off by the oil sands.”

Extracting oil from the vast majority of Canada’s oil sands is a very labor and capital intensive process. It requires much higher crude oil prices to justify the more expensive extraction method. Global players exiting their oil sands positions could be a warning sign that the price of oil getting above the $60 level is overly optimistic.

The upcoming IPO of Saudi Arabia’s state own oil company (Saudi Aramco) is another warning sign that the price of oil could be range bound. The company’s oil assets are valued around 2 trillion dollars. It begs the question; why would Saudi Arabia sell part of its state own oil assets to investors?

The simple answer is the Saudi’s need more revenue to pay for their government spending programs. I believe that this is another warning sign that the price of oil will stay lower for much longer. OPEC’s current production cuts are aimed at stabilizing the oil market so that the Saudi Aramco IPO will be successful in raising much need cash for Saudi Arabia.

The key question for the future of the oil market is for how long can a surge in U.S. shale supplies make up for the slow pace of growth elsewhere in the oil sector. The 5 year chart below illustrates the returns on owning two different oil ETFs. You would have lost money owning the Canadian oil ETF (XEG) and you would have broken even on the Spider ETF (XLE). 

In my humble opinion, long term buy and hold investors should avoid oil stocks. I have been bearish on Canadian oil companies for a long time because our oil and gas is land lock. Our only customer is the United States and they have already put a 20% tariff on softwood lumber. There are growing tensions around renegotiating NAFTA which could lead to a tariff on Canadian oil. Oil stocks are still trade-able but you need to be very nibble.

 

Do you agree or disagree? All comments are welcomed.

 

Disclaimer: This post is for discussion purposes only, do your own research before you invest.

 

 

Will Trump disappoint Wall Street & America?

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There is no doubt that the Republican Party was totally surprised and unprepared by the November election results. Trump’s management style is going to drive his management team, the media, most of the American people and the world nuts. A new reality show has come to Washington, “The Billionaire Apprentice”, who will be the first to get fired?

I think that there is going to be more than the usual amount of personnel turnover in the first six months. The media will be writing about how Trump can’t keep people and about all the chaos in the White House. The world has never seen an American president with this type of management style. It is going to make most of us uncomfortable.

The stock market has high expectations regarding less regulations, infrastructure spending, a new tax policy and the replacement of Affordable Care Act. Failure to deliver something that at least comes close to meeting those expectations is going to have a significant negative impact on the markets and the economy. Some market watchers believe that a correction will show up in the next 60 days if there are cracks in Trump’s agenda.

Being Canadian, I am not an expert on American politics. In my humble opinion, a civil war maybe brewing between Trump and the Republican Party on the implementation of a new tax policy and infrastructure spending. Repealing and replacing the ACA isn’t going to be easy without some bipartisan cooperation. Some republicans maybe hesitant to support some of Trump’s agenda in fear of losing their seat in upcoming congressional elections in Nov. 2018! Trump’s team could be stuck in the Washington swamp!

If you have any doubts that protectionism is at the top of Trump’s agenda, you clearly need to watch Trump’s inauguration speech. President Trump’s first few days in office was to pull out of the Trans-Pacific Partnership and signed an executive order to renegotiate NAFTA.

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My buy American and hire American playbook

Avoiding:

  • Auto industry (including part suppliers)
  • Canadian lumber producers
  • Health care and biotech
  • Oil & gas (watching U.S. fracking companies)
  • Retail & Restaurants
  • U.S. industrials that depend on infrastructure spending

Investments that could be Trump Free

  • U.S. banks (including some regional banks)
  • Tech stocks (including semi-conductors, cloud plays)
  • Some U.S. domestic stocks
  • Gold & silver stocks
  • Cash (in case of a correction)

What do you think? Has President Trump over promised and will he under deliver?

 

Carbon tax: a sign that oil prices will stay lower for longer

The federal government of Canada plans to impose a national carbon tax on any province that refuses to establish one on their own. They argue that putting a price on carbon will give people and companies an incentive to look for lower emission options to save money.

In reality, Canada is the second largest country in the world, just ahead of the United States and behind Russia However, our population is one-tenth the size of our largest trading partner, the United States and one-quarter the size of Russia. I estimate that 75% of Canadians live in rural areas where driving is a necessity and switching to electric heating or electric cars is way too expensive.

At the Golden Globe Awards, Meryl Streep called Canadian actors nice. I would like to add that we, as a nation, are dumb when it comes to energy. Refineries in Eastern Canada are spending billions to purchase about 700,000 barrels a day of foreign oil to meet customer needs while 3 million barrels of Western Canadian oil is sold to the United States at a discount due to lack of pipeline capacity between producing fields in Western Canada and refineries in the East.

Our governments rely on tax revenues from the oil and gas industry which are down with the price of oil. In truth, this carbon tax has nothing to do with lowering emissions but just another tax grab. This is a clear sign that the government believes a rebound in the price of oil is many years away.

The Canadian economy is fragile and the last thing it needs is yet another tax. The potential costs for the average Canadian family by 2022 is up to $2,569 per year. The carbon tax will also increase the price of food and clothing. It will mean lost jobs and make Canadian businesses less competitive.

Lack of pipelines makes me bearish on the Canadian oil patch

  1. It will take years to build the Keystone XL pipeline even if approved by Trump. Plus there will be a massive backlash, both on the ground and in the courts that could tie this project up for many more years.
  2. Prime Minister Justin Trudeau gave the green light to Kinder Morgan’s Trans Mountain pipeline expansion but I expect protestors will also delay this project.
  3. The Line 3 Replacement Program was also approved and is the largest project in Enbridge’s history. The anticipated in-service date for this project is 2019, pending U.S. regulatory approvals.

Additional reasons to be bearish on Canadian oil stocks

  1. Most Canadian oil companies are still losing money
  2. The profitable ones have very high price to earnings ratios (CNQ – EPS for 2017 is $1.04 or 39 times earnings and SU is 27 times earnings for 2017)
  3. Shipping oil by rail is way more expensive than by pipeline
  4. The biggest risk to the Canadian oil patch is Trump! He could put a 20% border tax on imported oil.

Foreign oil stocks that I own for yield

I bought some Royal Dutch Shell (RDS.A) for it’s 6.8% yield in my wife’s retirement account. The dividend is exempt from U.S. withholding tax because it is in a retirement account. Converting the U.S. dividend to Canadian dollars gives me a current yield of 6.8% times 1.32 or 8.98% which is much higher than owning bonds. Plus I can sell covered call options that could boost my returns by 5% or to protect against a fall in oil prices.

I also own Alerian MLP ETF (AMPL) which is a energy partners ETF with a 8% U.S. dollar yield. It has a 10.5% yield in Canadian dollars but does has a high management fee of 0.85%, still better than owning bonds. There are higher yielding limited partnerships but they carry more risk than owning an ETF.

U.S. Shale producers are on my watch list

The majority of these producers are still losing money. At the top of my watch list is Marathon oil (MRO) which is currently trading at $17. 45 but has a book value of $27.40. Their losses have been decreasing and the earnings estimates for a fourth quarter is for a loss of 15 cents a share. I am waiting for Marathon to release their results on Feb 15 to confirm that they are lessening their losses and that their revenue is increasing before I invest.

What oil stocks do you own and why?

Disclaimer: Please do your own research or consult with a qualified financial advisor.