Sugar High And Dry

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by: Eric Parnell, CFA
Summary

Corporate earnings have been on a sugar high for the past year.

This sugar high will soon be wearing off.

What are the implications for the U.S. stock market going forward?

“Kill yourself for recognition

Kill yourself to never ever stop

You broke another mirror

You're turning into something you are not”

--High And Dry, Radiohead, 1995

The Tax Cuts and Jobs Act of 2017 gave corporate earnings a sugar high. GAAP earnings on the S&P 500 Index increased at a robust double-digit rate throughout 2018. Much of these gains came thanks to the significantly lower tax rates for corporations that came thanks to the legislation that was signed into law at the end of 2017. But exactly how much of a sugar high did these tax cuts provide? And what are the future implications of these tax cuts now that the sugar high is soon to start wearing off?

Measuring the sugar high. Corporate earnings have been robust indeed throughout 2018, as demonstrated in the chart below. Year over year earnings growth was already rising at an impressive mid-teens clip even before the implementation of the tax cuts, and as each new quarter benefiting from the tax cut rolled into the annual number, the growth rate surged. It will all culminate in 2018 Q4 with all four quarters having benefited from the lower corporate tax rate, as corporate earnings are set to increase by more than +25% on an annual basis this quarter.

This leads us to the first challenge facing the U.S. stock market going forward. It appears the pace of corporate earnings growth is set to take a breather now that the full tax cut adrenaline shot is now in the system. Over the course of 2019, corporate earnings growth is projected to increasingly decelerate to just over +11% by 2019 Q4.

Now this still sounds like a decent growth rate, but it is important to remember that corporate earnings usually end up falling well short of expectations (barring some major change, of course, like major corporate tax cuts). And the further out the forecast horizon, the more likely that these earnings forecasts are too optimistic and will be revised lower. Put more simply, don’t hold your breath for +11%, as something in the range of +5% may be more realistic if the average downward revision holds. And something considerably worse by then also should not be ruled out.

This leads to the next important question, which is how much of a boost has come organically on a before tax basis from the growth of underlying businesses, and how much has come because corporations now have to cut a much smaller check to the government?

The above chart shows what earnings growth would have been if corporations were operating at the prior tax rate roughly in the neighborhood of 26% versus the current tax rate more in the 19% range. It should be noted that this is still a generous comparison, as it does not exclude the beneficial feedthrough effects of corporations putting these extra earnings to work to grow their businesses as the 2018 calendar year progressed. We see earnings growth rates are still solid, but far from robust.

A different look at earnings out in the mangroves. Another perspective on corporate earnings comes not from what are effectively the largest publicly traded companies in the S&P 500 Index, but instead from all public and private companies that file tax returns with the U.S. government through the National Income and Product Account (NIPA) data from the Bureau of Economic Analysis (BEA). Here we see that while corporate earnings on an after-tax basis and without adjustments has still been rising, it has been at a more modest single-digit rate. But on a before-tax basis, corporate earnings without adjustments have been flat to falling throughout much of 2018.

The J. Wellington Wimpy tax cuts. Now the above depictions of corporate profits potentially being weaker at the core than the headline numbers may suggest to some a justification for the tax cuts that took place at the end of 2017. After all, if the rate of as reported earnings growth was set to decelerate, these tax cuts provided a much needed boost. My objections to this conclusion are two.

First, the timing of the tax cut is dubious. The U.S. economy at the end of 2017 when these tax cuts were implemented was in the ninth year of what is by some measures the longest economic expansion in U.S. history. Indeed, the recovery has been sluggish, but it’s still been long. Thus, the decision to implement an aggressive fiscal stimulus during the expansion phase of arguably the longest period of economic growth in U.S. history is indeed unorthodox from a Keynesian theory standpoint. And the fact that this fiscal stimulus did came not with a projected surplus or deficit neutrality but instead is projected to add more than $2.3 trillion to the national debt over the next ten years makes the timing all the more questionable. For where in our economic textbooks did we learn that the government should undertake massive deficits during a period of prolonged economic expansion? How much flexibility will we now have in trying to smooth the business cycle when the next recession finally comes, potentially as soon as sometime over the coming year? Only time will tell.

Second, the distribution of the tax cut benefits is less than ideal. Now it would have at least been a reassuring consolation if the additional capital afforded to businesses was flowing into sustainable economic growth supporting capital expenditures and fixed investment. And while at least some of the money has shifted in this direction, the lion’s share has done nothing other than head back out the door in the form of share buybacks and dividends.

Consider the following. Over the first nine months of 2018, we saw expenditures by S&P 500 Index companies on new factories and equipment increase by around $76 billion. We also saw spending on research and development increase by roughly $45 billion. These are both solid and encouraging readings. But when these readings are juxtaposed against the fact that S&P 500 corporations also increased distributions to shareholders in the form of buybacks and dividends by $230 billion, which is more than double the increase in capital expenditures and R&D combined it raises the question as to whether the benefits derived from the cost associated with the massive increase in the national debt are being channeled in the most productive ways at the end of the day.

I appreciate the argument and have read the research demonstrating the value that buybacks and dividends provide, but even with this in mind, the debate still remains as to whether the vast majority of the tax cut benefits going to this purpose is the optimal outcome with the greatest multiplier effect for the U.S. economy over time. And none of this considers the fact that corporations are arguably worse than novice retail investors in buying high and not buying low. Certainly not necessarily the best use of capital on behalf of shareholders at the end of the day.

Bottom line investment implications. Corporate earnings were sent on a sugar high in 2018. As for the U.S. stock market, it did not dig on the lack of underlying nutritional value, as investors instead looked ahead to the inevitable sugar crash that may follow in 2019 and 2020.

Risks continue to accumulate for the U.S. stock market and the underlying economy. And much like what took place from 2000 to 2002, while the eventual recession in the U.S. may end up being relatively mild (after all, where are the accumulated excesses in the real economy), the next bear market in U.S. stocks may end up being particularly tough (now here I can find accumulated excesses for as far and as long as the eye can see).

Yes, U.S. stock valuations have improved as of late, but they still remain pricey on a historical basis and are even higher when you back out the sugar high effects of the tax cuts. After all, less expensive from the second highest valuations in stock market history is still expensive. Moreover, it is always important to remember that stocks can also be inexpensive and get quite a bit cheaper before it’s all said and done. I remember in 2007 when it was a point of reassurance that stocks were trading at a modest discount to their long-term historical average. Um, turns out, not so much reassurance after all.

Lastly, perhaps the most unfortunate outcome is that precious fiscal policy ammunition that could have been deployed once the next recession finally arrived has already been distributed. While sugar highs may be fun, pulling this fiscal policy lever so aggressively in 2017 will only make the clean up job harder during the next rainy economic day. And all of this assumes that those pulling the fiscal policy levers come the next recessionary episode still feel the same urgency to rescue corporations and the U.S. stock markets in the same way that investors have been conditioned over the past three decades. This will be an increasingly important point to consider over the coming two years.

Putting this all together, now remains a time to consider lightening up equity allocations on the margins. For U.S. stock market conditions may continue to get harder for stocks over the next many months before they start to get any easier.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Global Macro Research makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Global Macro Research will be met.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: I am long selected individual stocks as part of a broad asset allocation strategy.