Here is why the technology stocks zig every time that Congress zags on the healthcare reform bill. If you have not noticed the correlation, then you are not watching the market very closely.
As a professional money manager, that believes in active investing and not passive investing, I look at hundreds of stocks and charts every single day. From the time the market opens until the time that final bell rings, I am looking at what is going on underneath the surface of just the widely reported indexes.
Believe me, there is a strong correlation between the ebb and flow of the tech stocks and the healthcare reform debate. It actually has little to do with healthcare, but a lot to do with this….
The technology stocks are watching the healthcare debate as a proxy for the big debate that will follow. Not that healthcare is not an important debate, but tax reform is the cherry that the technology stocks are looking forward too.
It stands to reason that the companies that make the most money, stand to gain the most from a healthy tax cut. As a group, the technology stocks make the most money.
Consider that Facebook is expected to make about $20 billion in pre-tax earnings this year on about $40 billion in sales. That works out to a whopping pre-tax profit margin of about 50%. I know that it sounds obscene, but it does not sound so obscene if you are a shareholder in the stock.
Now consider that the U.S. currently has the second highest corporate tax rate in the world. With a 39.5% (includes state and local) corporate tax rate, the only country higher than us is Japan, at a whopping 41% rate (also including state and local taxes).
That $20 billion in profit will net the Federal, State, and Local governments an approximate $8 billion in taxes. That should fill a few potholes and pay salaries. It might even buy a few fighter jets and provide a lot of food stamps for the poor and needy.
That will leave Facebook with about $12-$15 billion in after tax profits depending on how good their tax accountants are. When we divide those after tax earnings by the amount of shares outstanding, we come up with $4.84 per share in earnings. This compares with $3.49 per share in earnings in 2016.
Facebook is looking for 39% growth in earnings this year vs. last year. Right now, the analyst’s estimates for 2018 are for $6.00 per share in after-tax earnings. This would represent another 24% increase in earnings. But remember, these numbers are not taking into account any future tax reform that could possibly come from the current Republican administration.
One again on Thursday, treasury secretary Mnuchin emphasized that the current administration still intends on passing meaningful tax reform. But then again, we were supposed to have a vote on healthcare reform by the fourth of July. The market takes this as a signal that meaningful tax reform is going to be very difficult to pass, just like healthcare reform is turning out to be.
If you don’t think that tech stocks and markets in general are not looking to Congress for their cue, then you did not see the market react favorably, almost the second that Mnuchin started talking on Thursday.
Of course it did, because tax reform is a big, big deal to the stock market. It is even a bigger deal to the companies that make a lot of profit. Unfortunately, tax reform will not help Sears Holdings (SHLD) at all, because they don’t have any earnings, but most of the tech stocks have very fat profit margins.
For the most part, they stand to benefit the most from meaningful tax reform.
Why are we even having this tax reform debate at all? Because, as I stated earlier, and as you can see from the chart above, the U.S. is at a big disadvantage when it comes to corporate tax rates. Our companies are paying about a 40% rate when companies around the world are paying a lot less.
No wonder U.S. companies were looking to move their corporate headquarters to Ireland, their corporate tax rate is just 12%. Their after tax numbers were sure look at lot better at a 12% corporate tax rate!
It is also no wonder that companies like Apple (AAPL) are leaving a lot of their profits overseas for now. If these companies were to bring back these trillions of dollars back to the U.S. they would be taxed at the second highest corporate tax rate in the world.
Another good debate could be had about how tax reform could boost the sagging U.S. economy. The fact of the matter is that our economy has depended on monetary policy alone for the last eight years. Zero percent interest rates got us all of 2% average GDP and huge pile of debt.
Former fed chairman, Ben Bernanke’s cries for some fiscal policy help fell on the deaf ears of the previous administration. In fact, it may be one of the main reasons that he was replaced by Janet Yellen. I have not heard her cry even once for fiscal stimulus since she took over the reins at the Fed.
Now that the monetary policy well is running dry, the U.S. economy is in dire need of some fiscal policy help. Without it GDP will continue to grind to a halt. This is another reason that the market is reacting almost immediately to any news of tax reform.
The market does not like shrinking GDP. This is what leads the economy into recession and the stock market into a bear. Just look to 2007, for the last time this happened. For this reason, I am not a passive investor. I believe in watching the big cycles of both the bond and stock markets, and acting accordingly.
I have been a bull since March 27th 2009, but when earnings of the S&P 500 eventually top out along with the U.S. economy, I do not want to ride the stock market into the ground. The last bear market hit passive S&P 500 index investors to the tune of 53%. That is not a sweet melody at all.
We badly need some monetary stimulus in the form of tax reform, along with a nice infrastructure bill, or this economy is going to continue to die a slow death. In the meantime a few Republican senators are holding up the healthcare bill, and monetary stimulus gets placed further and further into the future.
We need monetary stimulus sooner, rather than later. I believe that we will get it and the tech stocks stand to benefit the most.
Let’s return to my Facebook example.
Data from www.BestStocksNowApp.com
As I mentioned earlier, Facebook (FB) is expected to earn about $6.00 per share in earnings in 2018. The current consensus for average five year growth in earnings going forward is for 23.5% per year. With a forward PE ratio of 25.3 the shares currently trade at a very cheap forward PEG ratio of just 1.08.
Now let’s begin with $6.00 per share in earnings and grow those earnings over the next five years at an average clip of 23.5% per year. My spreadsheet calculations come in at potential earnings of $14.81 per share, five years from now. I know, that is a long time from now, a lot can happen between now and then, but these are the current expectations.
At a PE ratio of 19X, the stock would be trading at about $280 per share at that time. That gives the shares just over 85% upside potential over the next five years. This is very good, but let’s take a look at what a meaningful cut in the U.S. corporate tax rate would mean for Facebook.
The number that is being thrown around right now is the lowering of the federal corporate tax rate down from 35% to 25%. If that happens, it would have a significant impact on Facebook earnings and other profitable companies. It would also have a significant impact on S&P 500 earnings.
Let’s first look at the potential impact on Facebook’s earnings, then we will look at the overall earnings of the S&P 500.
When I go back to creating the same kind of pro forma income statements that I used as an analyst back in the early 2000’s, I come up with about a 10-17% increase in after tax earnings for a very profitable company like Facebook. The benefit becomes greater as they continue to grow and drop even greater profits to their bottom line in the future.
Those $14.81 in potential EPS five years from now, become $17.33 instead. Using that same multiple of 19X, we now have a five year target price of $330. Remember that the original target price was $280. This represents an 18% increase in the five year target price.
Now the stock has almost 120% upside potential over the next five years instead of 85%.
No wonder that the market is hanging on every word that comes out of Rand Paul and Steve Mnuchin’s mouth!
Finally, let’s look at the potential impact that a meaningful corporate tax rate cut would have on the overall earnings of the S&P 500.
Once again, here is what that all-important annual EPS chart looks like.
It is extremely important to remember that S&P earnings have been growing every year since 2009. Indexes and stocks follow earnings. As long as those earnings continue to grow, and the market does not get too expensive, the bull market will continue.
As of now, the consensus estimate for S&P earnings in 2018 are at $147 per share. In a continued low interest rate environment, I am using a market multiple of 18X. I have a 12 month target price on the S&P 500 of 2,650. This give the market 9.4% upside potential over the next twelve months. In my opinion there is still not another asset class that has better upside potential than stocks.
Now, what impact would a corporate tax rate cut have on the earnings of the S&P 500? I project a 6-8% after tax benefit to bottom line earnings for the index. This could potentially raise next year’s S&P 500 earnings from $147 per share to $157 per share.
Using that same multiple of 18X, we now get a one year target price on the S&P 500 of 2,825. This now raises the upside potential of the S&P from 9.3% to 16.6%. But, Congress better get busy!
Remember, the U.S. economy is in dire need of fiscal stimulus. Now you know why the market, and the tech stocks in general have been so volatile lately. There is an awful lot at stake right now.
I believe that healthcare reform and tax reform will get done before the end of the year. But, I am still bullish on the market with or without tax reform. With tax reform, I become really bullish, especially on the high profit margin technology stocks.
Disclosure: I am/we are long FB.
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.