Tax Reform: A Negative For The Stock Market

Part of the recent gains can certainly be attributed to the recent tax bill that has sent corporate tax rates to 21% from the previous rate of 35%. If stocks go up in anticipation of tax reform, investors are implicitly expecting that cuts will flow through into businesses’ income. It is important for investors to understand just how much of the tax cuts will be captured by businesses and how much will be captured by consumers in the form of lower prices. If every trucking company’s cost goes down by 5% due to cuts, then you can be sure that they will bid 5% less to move the freight: if they bid the same price, then another company will bid lower and win the business while still being profitable. In this hypercompetitive market, we would expect the cuts to almost entirely accrue to customers in the form of lower trucking prices. If it keeps its price quote constant, then it will win the business and will retain the whole benefit of the tax cuts. Investors in individual companies need to understand fundamental industry dynamics in order to determine how much benefit they will see from the tax cuts. Investors in broad index funds, or at least those with a diversified stock portfolio, need to ask a different question – how do after-tax earnings react to changes in tax rates over time? Will tax cuts lead to higher corporate earnings over the long run, or will the cuts be passed on to consumers? Will equity investors enjoy higher earnings and returns as a result? This is the most important measure of profitability – how much money does $1 of investment generate after tax? If this number trends up or shows clear jumps when the corporate  rate is changed, we can assume that cuts will have a large effect on corporate earnings.On the other hand, if returns stay the same over time no matter what, we can conclude that US businesses are very competitive and that cuts won’t lead to markedly higher earnings. Competition in the marketplace matters more than the tax rate or whoever is in political office. For reference, corporate tax rates were between 46-50% up until 1986 and have been around 35% since – in the face of lower taxes, the average after-taxes ROE has remained the same. When you look at the data, all you can see is the result of competition;  rates and every other factor fall by the wayside. This obviously means that any run-up in stocks because of the expectation of tax reform has been unwarranted. This leads us to one important factor that hasn’t been discussed in great detail: all else equal and assuming a decently strong economy,  cuts will lead to higher interest rates. If  cuts do bring about interest rate increases, and there are indications that that is already happening, that will have a hugely negative effect on stock values, since a 7.8% potential return in stocks isn’t attractive compared to a 4-5% yield on treasuries.Thanks For Reading!

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