How Tax Reform Slays the Bull Market

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Have you ever gone outside your comfort zone? It can be uncomfortable. Recently, I was taken outside my comfort zone as my fear of open heights and the presence of many roller coasters at a local amusement park collided. That experience got me thinking about this week's column idea, which is going to take you outside the comfort zone of conventional thinking.

Specifically, you'll be taxed with the unconventional thought that a tax reform plan just may be the thing that slays this bull market.

A 9-Month Gestation Period

For the last nine months, tax reform has been at the tip of every market pundit's tongue as the one thing the stock market is pining for since it would help the economy break free from its low-growth stupor.

The impetus for the breakout would be lower tax rates for businesses, lower tax rates for individuals, and an incentive for businesses to repatriate cash held overseas. Other measures would help, too, yet that triumvirate is at the core of why economists and market pundits think economic growth and corporate earnings growth would accelerate to a new level.

It is a logical assumption.

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Consumers would have more disposable income, which would induce increased spending, and businesses should see better profitability, which would induce increased hiring and investment to meet the pickup in end demand. In short, tax reform would trigger a positive feedback loop and escape velocity for the economy.

Real GDP

Davids vs. Goliath

Loops and (escape) velocity were in abundance on the roller coasters at Six Flags Great America, which features the aptly-named Goliath.

The latter offers the world's tallest drop for a wooden coaster at 180 feet, the world's steepest drop for a wooden coaster at 85 degrees, and the world's fastest wooden coaster at 72 mph. Oh, Goliath also includes a spiraling inverted zero-G stall (it makes me nervous just writing about it).

Goliath looms over the park, such that the other coasters look more like David.

My older kids and I slew those Davids and had a great time doing it. My fear of open heights was put to the test and I passed, but my final exam was Goliath. I'll share those results in a bit.

For now, I just want you thinking about roller coasters because they provide a good analogy for the issue of tax reform.

Actually, it's a good analogy as it relates to the market's sentiment on the tax reform effort. We can't tie it directly to tax reform for the simple reason that an actual plan hasn't been offered yet.

There have been some general talking points, which we cited above, some efforts to qualify when a tax reform plan could potentially pass in Congress (late this year or early next), and some misgivings about whether tax reform can even happen given the GOP's infighting during its failed attempt to repeal and replace the Affordable Care Act, as well as the deep partisan divide that exists between Democrats and Republicans.

The sentiment toward tax reform has been like a roller coaster ride that twists and turns, and even throws you for a loop, before ultimately returning you to your starting location. That is basically where sentiment sits today on the matter of tax reform, which hasn't left the station yet.

Tax Reform Optimism

Let's now embrace the notion that tax reform does happen and that it includes all of the bells and whistles that will lead to stronger economic growth, as in sustainable 3.0%+ GDP growth.

That would presumably be greeted with a great deal of enthusiasm by the stock market, which in more recent months have been doubting the ultimate force of a tax reform plan and has been forced to consider the possibility that a tax reform plan might not come to fruition.

Wharton School finance professor Jeremy Siegel, who has been correctly bullish on the stock market for some time, suggested this past week that the Dow Jones Industrial Average could hit 24,000 by the end of the year if Congress can at least pass corporate tax reform.

We're not going to forecast any levels, but we agree with the assumption that the stock market would respond favorably to a tax deal getting done. That thinking stems in part from forecasts that a cut in the corporate tax rate could increase earnings per share growth for the S&P 500 by as much as 10%.

That would lessen some of the valuation concerns hanging over the S&P 500, which, at 17.7x forward twelve-month earnings, trades at a 26% premium to the 10-year historical average of 14.0x. Professor Siegel argued, however, that the persistence of low-interest rates lessens the concern over that historically high valuation.

SP500 PE

If the S&P 500 simply held at its current record-high level, it would be trading at 16.1x forward twelve-month earnings based on a 10% increase in the EPS growth estimate. In other words, it would still be trading at a premium to its 10-year historical average, although there would be less concern if interest rates remained low.

Like my Goliath experience, I'll come back to that interest rate factor in a bit because it looms like Goliath over any bullish market outlook associated with tax reform.

Aggravation Brewing

The other side of tax reform, then, could initially be a happy place for the economy and the stock market. It is expected that it would:

  • Spark stronger economic growth
  • Ignite stronger earnings growth; and
  • Stir some dormant animal spirits among retail investors

The confluence of those factors should drive up stock prices, but at some point, they should also do the following:

  • Spark increased inflation
  • Ignite higher market rates; and
  • Stir the Fed's hawkish spirit

Higher interest rates would eventually be the offset for a bull market move in much the same way the persistence of low-interest rates has breathed extended life into the current bull market, which is now 8+ years old.


The headwind of those high rates wouldn't be immediate because they would be seen as being consistent with a strengthening economy, yet a 10-yr note yield above 3.00%, which is certainly possible if the economy and the stock market accelerate as expected in the wake of tax reform, will get in the way of multiple expansion.

Notably, Leuthold Chief Investment Strategist Jim Paulsen, whom we have enjoyed listening to over the years, rightfully observed to CNBC on Friday that the stock market has a good thing going right now in that inflation and interest rates haven't been aggravated despite a fully employed economy, rising real wages, a restart of the corporate earnings cycle, and strong confidence among business and consumers.

Paulsen added that the bull market could "continue to forever" if those factors can continue without aggravating inflation and interest rates. To be fair, Paulsen went on to say that he thinks they get aggravated eventually, but just not anytime soon and that the bull market carries on through the end of this year.

It is a reasonable argument, yet it touches on the very reason why tax reform could slay this bull market.

To think market rates will remain low and the Fed will sit by idly as economic growth accelerates and inflation picks up on the other side of tax reform, or to think economic growth and inflation won't pick up with consumers having more disposable income to spend, is tantamount to thinking it is different this time.

History has shown of course that thinking it's different this time is a setup for a painful reminder later that things are in fact the same. This was among the many cogent points highlighted recently in a cautious-minded memo from highly-regarded investor Howard Marks of Oaktree.

What It All Means

The US economy isn't doing great, but it is doing okay; meanwhile, corporate earnings growth has been great. That is the condition of things without any fiscal stimulus.

The Federal Reserve has been raising the target range for the fed funds rate in a deliberate fashion and it will soon embark on capping its reinvestment in Treasury and mortgage-backed securities.

It has been slow to raise rates further because the inflation readings have been low, but there is still a prevailing sense that the factors holding down inflation are transitory. Accordingly, the Fed remains inclined to remove its policy accommodation, albeit in a gradual manner.

That is the Fed's stance before any fiscal stimulus has been passed, so if a tax reform plan is passed, the stock market will eventually have to contend with the idea that the Fed may think it has to do more to remove its policy accommodation — and the Fed would do more, perhaps much more, if inflation picked up on the other side of tax reform.

Now, getting back to my Goliath experience.

I must confess that my fear of open heights won out. The thought of being in a little car 180-feet in the air with nothing but an 180-foot drop on either side of me was too much for this roller-coaster rider to bare. Alas, this David didn't slay Goliath.

To a certain extent, the stock market has been a Goliath, standing tall in the face of many slingshots because it has been supported by low-interest rates. If the passage of tax reform pays off for the economy like it is being advertised, though, it is reasonable to think higher interest rates will follow suit and just may be the thing that slays this bull market.

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About Patrick O'Hare