Market Insights: Trump's Tax Trumpery

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Summary

The recent market rally has been driven by P/E expansion.

The P/E expansion has been driven primarily by hope of tax cuts and FOMO.

The historical data shows that tax cuts and economic growth are independent of each other.

Trumpery is defined as an attractive item of little use or value by the Oxford Dictionary. I find it rather amusing that such a word exists given the name of our incoming 45th President. Now what has transpired in the market over the past couple of months can be described by many words, but I like the word mind-boggling. I have certainly profited nicely in this time period, so I am not complaining about this. However, the fact that I have profited so easily, given all that has happened is shocking to me.

When the unexpected happens, I like to distill things down to understand them better. In this case, the distillation process proved too easy. Take a look at the graph below which shows the P/E ratio of the S&P 500 (NYSEARCA:SPY). It plots the S&P 500 vs its P/E ratio.

In the absence of earnings increases, the P/E multiple drives the prices higher and lower. To that effect, 100% of the recent price movements have occurred as a result of multiple expansion since the beginning of November.

The same has happened with the Nasdaq (NASDAQ:QQQ):

And the Russell 2000:

Now why have the mutiples expanded from 19.5x to 21.2x in a span of three months for the S&P, or from 42x to 49x on the Russell 2000? Put differently, why is the S&P now worth almost 9% more than it was 3 months ago? Or why is the Russell 2000 worth over 17% more than it was in the same time frame?

Surely the economy hasn't changed in three months. I would argue that uncertainty has increased. I would argue that businesses are on the defensive right now. The P/E multiples were not at a depressed valuation when they were at 19.5x in November 2016. Have a look at the historical P/E ratio of the S&P 500 for yourself.

So why has the market repriced itself? There are two good explanations for this. Sentiment and taxes. They both feed off each other. Sentiment improves when people feel that they will be taxed less. When people think of a few extra dollars in their pockets in the future, they feel less somber and more likely to experience an improved mood, even if for the briefest of moments. Therefore, in my estimation, sentiment and taxes are linked together very tightly.

While the benefits of tax cuts to stimulate growth and the animal spirits of the market are touted by politicians, the media, my uncle Bob and the likes, historical evidence for this has shown been shown to be elusive. I recall reading an interesting article in the New York Times a few years ago. Funny enough, it was around the time Romney was running for office with his economic plan that featured, wait for it... TAX CUTS! The article had one graph which told the story in and out of itself. Here it is:

The Y-axis features economic growth, and the X-axis features time. When Bush was dialing up taxes, the economy grew. When Clinton dialed up taxes in '93, the economy continued growing. When the other Bush cut taxes in 2001 and yet again in 2003, the impact on growth was not positive. In fact, growth slowed. A very important research paper published by the Congressional Research Service looked at the personal tax rates from 1945 onwards. All it goes to show is that reducing tax rates at the top 1%, merely serves to make the top 1% richer without any impact on economic growth. You can find this fine piece here.

So what does this all mean?

  • Corporate tax cuts don't result in economic growth
  • Personal tax cuts lead to concentration of wealth with no resulting economic benefit

If you are a believer, as I am, that the economy needs the middle class to succeed, then there needs to be more than just tax cuts for the American public. And until this happens, all this ballyhoo around the benefits of lower taxes that is driving the markets will soon reveal itself as nothing more than trumpery.

Disclosure: I am/we are long SPY PUTS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.