Tax Cut Fever

Donald Trump accomplished what may be the signature achievement of his term with the passage of the recent tax reform act in late 2017. The reforms, long sought by Republicans and corporate America, were passed in record time and now enable the GOP to point to a major legislative success in advance of the midterm elections later this year. Key provisions of the act include a major reduction in the corporate tax rate (from 35% to 21%), a slight reduction in the maximum individual tax rate (from 39.5% to 37%), elimination of the personal exemption but increase in the standard deduction, and a limitation of state and local tax deductions, just to name a few.

By any measure, the bulk of the benefits flow to corporate America, and Wall Street has reacted as expected. Since Trump’s election, the financial markets have been pricing in the likelihood of a corporate tax cut, providing a well-supported floor under prices. Through December, the S&P 500 had posted positive returns for 12 months in a row, something that has never occurred before. As tax “hope” became “reality” stock prices took on a life of their own, rising in a nearly vertical, or parabolic, trend.

DOW Graph

The swoop up in stock prices underscores the bullish sentiment pervading the markets.  There seems to be a “get me in at any price” mentality developing, and readings of investor psychology are bullish.  Investors Intelligence’s advisory sentiment survey shows bullish sentiment at a recent peak of 66.7% (a 32-year high) and bearish sentiment at 12.7% (a 32-year low).  These are not just high levels, but extreme levels.  We have cited overly bullish psychology, along with overvaluation and overleverage as reasons for investors to tread carefully.  Moreover, these risk factors are an open secret on Wall Street, widely acknowledged in research reports and blogs.

Yet stocks have continued to not just rally, but rise nearly parabolically.  How do we reconcile the three risk factors that have marked previous market peaks, overvaluation, overleverage, and overly bullish psychology, to the strong uptrend of the major indexes?

The most obvious reason is the passage of tax reforms, which significantly changed the landscape for corporate America.  By reducing the tax burden it’s hoped that companies will invest in more capital spending in the US, reduce the debts accumulated over the last decade, and importantly, raise wages.

Numerous companies have already stepped to the fore with announcements of worker bonuses and wage hikes.  Corporate managements are generally citing a profitable outlook for 2018, with many naming tax reform as one reason for their upbeat forecasts

Moreover, tax stimulus has arrived when, for the first time in a decade, all the world’s major economies are growing together.  This has created a synchronous wave of growth that is creating jobs, lifting fortunes and reinforcing the virtuous circle of rising demand, wages, and profits.  More money in consumer pockets gives businesses more reason to expand.

Therefore, a positive profit outlook, that has been made even more so due to tax cuts, has Wall Street raising their earnings estimates.  With them rise the valuation of stock prices, and the market is bidding up their estimates of stock prices.

Higher earnings estimates also are prompting analysts to take a look at their valuation models.  One standard is to look at the price /earnings (p/e) ratio of the market as a barometer of value.  With a rise in earnings, the “e” of the p/e ratio is larger, making the overall p/e ratio fall, all else being equal.  Earnings would have to rise significantly to bring the stock market back to “fair value,” but any earnings growth helps mitigate the valuation worry.  With current valuation levels closing in on 1999-2000’s all-time high, any moderation of today’s extreme valuations would be welcome.  Thus, the strong economy explanation for today’s parabolic price ascent argues that improving fundamentals will overwhelm today’s valuation extremes, so we don’t need to worry about this market indicator.

Another way to interpret today’s market is that we have reached a permanently higher level of valuation.  The notion is that rising earnings and historically low interest rates have combined to give us the best of all worlds, and we need to change the way we measure valuation and interpret stocks and bonds as cheap or expensive.  Thus, in this view, today’s parabolic rise in stocks is simply an adjustment to that new reality.

There is precedent for tectonic shifts in the way we’ve viewed securities.  After the Great Depression, for instance, the percentage yield on stocks was always higher than on bonds.  The wipeout in stock values after the 1929 market crash made away with the view that stocks were for capital appreciation, and they were treated as income instruments.  In the 1960s, “modern portfolio theory” changed that view, and earnings growth and capital appreciation again became the accepted way to view the role of stocks.

But this rationale sounds eerily like the “this time is different” pronouncements of cycles past. Each major peak looked like a new era at the time either due to new technology (radio, semiconductor, internet) or some financial innovation (growth mutual funds in the late 1960s, derivatives and securitization in the 2000s). However, each epoch was marked by extremes of sentiment and leverage, much as it is today, so we’re hesitant to endorse the view that we are in a new era.

Finally, there is the view that we are in the final innings of the bull market, and that overvaluation, overleverage, and overly bullish sentiment are symptomatic of that.  In other words, it’s the same old cycle repeating itself.  Today’s stage of the cycle, though, has moved from optimism to euphoria, and that euphoria has masked the high risk the general public is now embracing.  It is less about accounting fundamentals than it is the irresistible pull of crowd behavior.  This phenomenon of mass psychology, of course, has lots historical precedent, from the gold bubble in the 1970s to bitcoin today.

Moreover, the economy has always looked good at market peaks, and at the time there was no reason to doubt that good fundamentals wouldn’t carry us through.  But it is important to remember that rules governing investor behavior have not been repealed.  The three key yardsticks of market health have signaled trouble at each of the important peaks in the past, so why should we begin to disbelieve the message that extreme readings of valuation, leverage, and sentiment are sending now?

Overvaluation, overleverage, and overly bullish psychology are all conditions that have been present at previous market peaks, but they are not actual sell signals.  What, then, should investors look for to confirm that the risk conveyed by these indicators is coming to fruition?

The first breakdown to look for would be a sell signal in the NYSE advance/decline line.  The advance/decline line records the net number of stocks rising every day, and then cumulates them over time, so it looks like a mountain chart.  In bullish phases, like now, the line will rise.  Conversely, in bearish periods the line will fall.  We use a point and figure chart of this measure because it provides clear buy and sell signals, and the current status is bullish.  We will be reporting the status of this measure in upcoming Market Outlooks, but anyone wishing to check its current signal can call Praxis’ office at any time.

Secondly, we would look to the NYSE Bullish % to confirm any deterioration in the advance/decline line.  The Bullish % measures the percentage of stocks on buy signals on the NYSE.  Because it is based on point and figure charts, the signals are unambiguous, therefore easy to tally up into a percentage of stocks on buy signals.  The Bullish % will rise in bull markets, as a rising percentage of stocks give buy signals.  Weakness in this measure implies that, broadly speaking, uptrends are starting to fail and develop bearish patterns.  Currently, the bulls need not worry on this score, as the bullish % is at 72% and rising.  It will take at least several weeks of weak markets to meaningfully turn this indicator to negative status.  We can provide this indicator to anyone interested in following its progress.

NYSE Bullish Graph

A third signal to look for would be “bearish failure swings” in key stocks.  A bearish failure swing is the change of pattern from higher highs and higher lows to a pattern of lower highs and lower lows.  It’s easiest to visualize as the transition from an “up” staircase to a “down” staircase.  If the leading stocks struggle to get to new highs, and then start to exceed previous lows, it can be a sign that the market is changing character.

Failure Swings Graph

It is no secret that the biggest capitalization stocks are leading the current rally, and that small and mid-cap stocks are lagging behind.  This is also symptomatic of the late stages of a bull market, as the “generals” (biggest stocks, and easiest to sell) are not followed by the “soldiers” (smaller stocks).  Thus, we would look for bearish failure swings among the Dow Industrials as a sign that a correction was likely.

Finally, one can look to the junk bond market for signs of trouble for stocks.  Junk bond trends are much more dependent on company cash flows than the direction of interest rates, as it is the ability of companies to pay their debts that is foremost in junk investors’ analysis.  Thus, junk bonds have often been called the “canary in the coal mine” for equity investors, as a decline in junk bond prices has often presaged a subsequent decline in equities.  As long as cash flows are strong and liquidity is plentiful, junk bonds should hold their own.  Investors can easily monitor the trends of two large junk bond ETFs (symbols: JNK and HYG) to track this measure.  Currently, junk bond prices are flattening.  Moreover, they made their most recent highs in the summer of 2017 and therefore are not confirming the new highs in stocks.  Whether they live up to their reputation as an early warning for stocks remains to be seen, but this is one area where a sell signal may be developing.

Junk Bond Graph

Tax cuts, synchronized global growth and (artificially) low interest rates have emboldened the bulls, who have been driving stock indexes up at a near vertical pace.  These are all bullish factors, but we don’t believe that makes it “different this time.”  The triple warnings of overvaluation, overleverage, and overly bullish psychology have signaled trouble in a timely fashion in the past, and we believe they are doing so now.  High bullish psychology means that everyone is fully invested.  High leverage (margin debt) implies there is dwindling cash with which to drive stocks higher, and also that highly leveraged investors have little pain tolerance for a correction.  Our concern is that bullish sentiment collides with high leverage to turn an ordinary correction into a snowballing avalanche of selling.  Whether this takes the form of a short but painless “flash crash” or a lengthier correction is anybody’s guess, but we would urge investors to fight the tendency to be complacent at this time.

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