This article is based upon our year-end summary to subscribers of Friedrich Global Research. It represents our views of the macroeconomic environment that will prevail throughout 2018 and beyond. In it we will explain our thinking about the impact of tax reform on U.S. equity markets (including examples using some of our model portfolio holdings), why we believe there could be a shift of significant magnitude out of bonds and into equities, and what events (which we do not expect to occur) could change our minds about the future. We hope you enjoy our holiday outlook and please ask questions in the comment section if anything requires further explanation.
Powerful Change is coming thanks to Tax Reform
The year 2017 was a great one for our Friedrich Algorithm as its stock picking was truly amazing, but it is our belief that the next six years will be even more incredible. We believe that the Dow Jones could hit 50,000 by 2024. We are very conservative investors/analysts, and we are not known for making wild statements, but we believe that prediction has a strong chance of happening because of the foundation created by the new tax reform bill will result in a massive boom for corporate America on Main Street (main street being where companies operate in contrast to Wall Street where the stocks are priced). Since 99% of our Friedrich analysis is done on Main Street, our system should start seeing some amazing spikes in valuations in about six months from now, and as a result, we believe that Wall Street will soon follow (even though the Spin Doctors there will try to get investors to sell their stocks and try to panic the markets, so that Wall Street's power players can step in and steal those shares). It's the basic bait and switch, but this tax reform bill is such a massive paradigm shift that we don't even think the spin doctors will be able to control what is coming.
We realize that the markets have not yet reacted strongly in either direction yet but there is a reason. It is year end and there is a lot of repositioning going on in the markets. With the lower rates for corporations and pass through entities (LLC, LLP, and sole proprietor) some will be locking in the higher tax loss by selling big losers before year end. There is always some rebalancing of portfolios at this time of year, with major winning positions now making up too large a position some of those great winners of the past year will be trimmed. Some of the profit taking will probably not happen until after the end of the year for those entities unable to take advantage of capital gains tax rates since investing is a primary business activity. And then there is always the window dressing that goes on in funds to make the managers look smarter than they really are by showing prospective buyers that they owned winners at the end of the year (after selling losers and replacing them with companies that have fared better).
There may also be a lot of uncertainty among analysts and investors alike as to how much the tax changes will affect individual companies. That may take a few months to get sorted out and many will probably wait for results from the first (or even the second) quarter before trying to determine the full impact. Once everyone understands the full effect, the buying will get underway. We cannot predict when it will happen. Some will try to get in ahead of the run and others will wait, how many of which do what when is still a mystery that will reveal itself over time.
Examples of how tax reform will help corporate America
The following are just a few examples of what is coming for some of our holdings that should clearly indicate why we will be ignoring Wall Street's guidance going forward as the news on Main Street is just way too powerful. The following is just based on the facts and can be spun no other way than very good news.
According to the Tax Plan, while the government had previously waited until a company repatriated cash to levy a 35% tax, it will now impose a 15.5% tax on cash earnings. Apple has the most to gain in absolute dollars with more than $250 billion in offshore cash at the end of the last quarter. Moody's Investors Service estimates that the iPhone maker will have about $265 billion overseas at the end of the year. Gene Munster of Loup Ventures expects Apple to bring back $214 billion in cash and increase its share buyback by $69 billion. This is why you have seen Warren Buffett use his war chest at Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) in order to back up the truck on Apple shares as he knows that the company will take full advantage of this and buy back tens of $billions in shares. It is our belief that those shares will hit $200 in 2018 as a result. Starting next year, companies will pay 10.5% or 13.125% on half of the income from subsidiaries outside the U.S. If they sell products or services produced in the U.S. in foreign markets, they will pay taxes of 10.5% or 13.125% - a discount to the new 21% corporate tax rate.
This provision should reduce the desire of U.S. multinationals to move jobs and production overseas. It may even bring some back or even lure other multinationals away from high tax countries. But the bottom line for Apple is that it will be less necessary to play games with profits to avoid paying taxes. And that should also have the same effect on other U.S. corporations.
Now let's discuss our TJX Companies (TJX), and why 2018 should be a boom year for the company as a result of the tax reform.
TJX routinely generates more than 80% of its segment profit in the domestic market. Assuming the company's effective tax rate declines to roughly 25-26% from 38% in recent years, it would increase after-tax profit by about 20%.This means that if TJX meets analysts' pre-tax profit expectations next year, its EPS would likely surpass $5, including the impact of tax reform. Given that TJX stock has frequently traded for at least 20 times earnings in recent years, the $100 mark should be easily within reach for TJX during 2018.
2017 was a super year for our Home Depot, Inc. (HD) as those shares have risen by nearly 33% in 2017, outpacing the S&P 500 Index and its biggest rival, Lowe's Companies (LOW). Home Depot stock has gained almost 12.5% since September 1st, and part of the reason for the increase is that the sector has come to life. The Consumer Discretionary Select Sector has risen by nearly 7.5% in 2017 as everyone is expecting a capital expenditure boom going forward. Under the new tax law, capital expenditures on short-lived assets (many of which are sold by Home Depot) will be written off 100% in the year they are made, which will reward companies that decide to build and equip new factories, paint rooms, make renovations to existing facilities, etc... Home Depot and other holdings of ours, like Sherwin-Williams (SHW), will benefit from this clause in the new tax law.
Another reason for the boost in Home Depot's stock is that investors are anticipating the potential tax savings will be a big boost in earnings for the company. Based upon the latest analysis, it looks like Washington's tax reforms could reduce Home Depot's effective tax rate from 37%, as of the latest quarter, to around 24%. To get the lower 24% tax rate, we added 3% state and local taxes to the proposed 21% rate. That tax cut alone would have boosted Home Depot's third-quarter net income by about $500 million (~22 percent), or about $2 billion annually. That's no small chunk of change. Tax reforms' similar impact on 2018 and 2019 earnings growth could sharply bolster Home Depot's stock. Then when you add in the boom from its customers taking advantage of the tax plans capital expenditure clause (benefits any size company from C Corps, to LLCs and S Corps) where even small firms throughout the 50 states will benefit as well, the impact is magnified even more. With tax reform, all companies, regardless of size, benefit which should even make libertarians smile. This is the old Home Depot tax rate which will now be down by at least 1/3rd if not more.
On December 22nd, we backed up the truck to load up on Gilead Sciences (GILD) as the prospect of tax reform has had drug makers and Wall Street salivating for months.
Repatriation of cash held outside the U.S. could be the most important part of the Republican tax bill for the sector, according to a recent Credit Suisse report, which found that American biopharma companies make up one-third of the top 30 U.S. companies with the most offshore cash. The tax rate for repatriated offshore cash has gone from 35% to between 8% and 15.5% - a major tax break that could make a slew of deal making and share buybacks possible.
The biggest potential winner in the sector is Gilead Sciences, Inc. which has $32 billion in cash parked outside of the USA of its $41 billion in total cash. When you figure that the entire company sports a market cap of $94 billion, that $41 billion in cash means that once the $32 billion is repatriated, the company could eventually repurchase up to 40% of its shares on the open market. With the Hep-C franchise cure rate nearing 100% and its AID's franchise fully invested, its recent acquisition of Kite Pharma should benefit from any investment the company makes in the future and the rest could just be left to share buybacks and dividends. As you can see from the table below, Gilead Sciences should benefit the most from the new tax reform bill.
The reason we significantly increased our holdings on a whole slew of stocks on December 22nd is because the next few years should be boom years for the stock markets as they surely will be for Main Street. We could write another 20 pages on how our portfolios will benefit from this new tax law, but instead just explain that eventually, when the tax plan gets fully implemented on Main Street, Friedrich will also be showing huge upgrades in its data files and charts as super scores of 3 will become 4s, 4s will become 5s and 5s will become 6s as the tax rates falling from 35% to 21% and the repatriated cash flooding back to the U.S. will just ignite Main Street. This, of course, will be inflationary but since interest rates are so low, it will take a significant number of rate hikes just to get short-term rates back to the historical average of the last 62 years for the Federal Funds Rate:
Source: St Louis Federal Reserve Bank
An Epic Shift may be coming
As a result, bond investors will start selling bonds and putting that money into stocks for when interest rates rise bond principal (price) falls. This too will be a major upward catalyst for the stock market as globally there are about $100 trillion invested in bonds vs. $64 trillion in stocks if that were to just switch to a more balanced $82 trillion vs. $82 trillion that will be an $18 trillion boom to the global stock markets. With this major paradigm shift for the USA, most of that bond money will most likely be heading to the USA and it will be going in Mega-Cap stocks, like Apple for example, and that is another reason we see 50,000 on the Dow by 2024. Bold prediction for very conservative guys, but when you do the tax math from a 35% tax rate to 21%, the drop in the tax rate that companies will be paying could be staggering, not just one time but permanently! It will have the effect of boosting free cash flow tremendously and when you add the repatriation tax rate falling from 35% to 10% [(35-10)/35=71%] drop in taxes paid we thus will get a TRUMP GOLD RUSH into stocks as all this is real cash money coming back to Main Street. The math is in our favor and those are facts and not guesses.
So we have been waiting for a long time to see our government finally get its act together and get its greedy hands out of Main Street. Now that it has finally happened, this could be the roaring 20s all over again, except it will be the 2020s. We have never seen anything look this promising in 44 years of studying the markets and finally feel confident that good times are coming. Donald Trump (despite how you may feel about him), with this move, will go into the history books and create a super economy on Main Street as the new tax law will put money back in the hands of corporate Main Street and everyone, especially investors, should benefit as a result as this super rising tide will lift all boats from the rich even to the poor (more jobs and training by corporations to keep up with demand). When you add in that we have a Main Street Algorithm called Friedrich that has a unique ability to analyze how companies are doing on Main Street, we may benefit even more as a result.
What could possibly go wrong?
There are only three things that we believe could derail or create a drag on growth in 2018. A trade war, demographics or an inverted yield curve.
We do not believe that a trade war is in the cards despite presidential tweets that may indicate otherwise. We think this is just posturing to make improvements in existing and future trade treaties. The President just wants to create an artificial position of greater strength rather than weakness for negotiating purposes. At least, that is what we hope. But if a trade war were to be created, especially one on a global scale, all bets would be off because we believe that threat of higher tariffs by a tax bill working its way through Congress in 1929 was the catalyst to begin the crash and subsequent Great Depression. In other words, a trade war could change everything for the worse. It is a concern but we really don't expect one.
Demographics are a problem but we believe it will create less of a drag on the global economy than some predict. Aging populations in many developed markets, especially Europe and the U.S., could create a drag on consumption as retired folks generally have less to spend than those who work. However, we believe that one mitigating factor will be that many people who retire will find that they have not saved enough and will re-enter the workforce. So, initially, the workforce could continue to fall but then begin to rise again early in the next decade. As the next generation in the U.S. comes of age the workforce will stabilize. As those of retirement age decide retirement is not really that easy without enough money the workforce will begin to rise again. Only about 20% of people in the U.S. have enough savings to retire by the time they reach retirement age, so what will the other 80% do? Some will just make do, but others will work.
We are not so certain that Europe will be as lucky since many countries there do not have a large generation coming of age and populations will continue age as a result.
The yield curve (ten-year note rate minus two-year note rate) is narrowing. This is a bad harbinger of things to come. If the Fed continues to raise its benchmark Fed Funds Rate (rate at which banks lend to each other overnight) and the longer term bonds do not rise as fast we could see the yield curve turn negative. In each of the times when this occurred in the past, the economy has sunk into recession soon after - every time!
But the Fed has the ability to keep this from happening. It can keep the rate hike process moving at a snail's pace, for one thing. It could also reduce its balance sheet faster to increase supply of bonds in the market which would lead to lower prices and, in turn, higher interest rates on long maturity bonds. So, while we are concerned we are not anywhere near panic mode. It would require the Fed governors to be idiots. We are not saying it is not possible, merely that we believe the Fed can maneuver the course well enough to avoid an inverted curve. Or, at least, we certainly hope so.
Well, this should be obvious but we will state it anyway. We believe that once the impact of the tax reform bill becomes clear, the U.S. economic growth will rise above 3% and the existing bull market in stocks will become the longest in history.
May the force of tax reforms work to your advantage in the coming year. Happy Holidays and get ready for what should be a great 2018 and beyond.
If you have any questions, please feel free to ask them in the comment section below and don't forget to hit the "Follow" button next to my name at the top of this article. For those who would like to learn more about my investment philosophy, please consider reading "How I Created My Own Portfolio Over a Lifetime."
Disclosure: I am/we are long AAPL, TJX, SHW, HD, GILD.
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.
Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.