UP AND DOWN WALL STREET Wall Street Counting Its Tax-Cut Chickens Early News of GOP plan pushes up stocks, but celebration could be premature. By RANDALL W. FORSYTH Sept. 30, 2017 12:01 a.m. ET Getty Images Talk about a tale of two cities! Wall Street celebrated the prospect of the first real tax reform in over three decades by sending big- and small-cap stocks to records last week. Alas, the reality is that the celebration, at best, is a bit premature. The outline of the tax plan from the Trump administration and the congressional Republican leadership spurred much discussion and anticipation about its impact on the economy and investments. But minor questions remain—such as what the tax changes actually will entail and when they might be passed. Assuming your attention wasn’t totally consumed by the crucial news about football players kneeling, you already know the plan’s key particulars. Among them: the collapse of personal tax brackets from seven to three; the doubling of the standard deduction; the elimination of the deduction for state and local taxes; allowing the “pass through” of business income at a 25% rate, instead of higher, personal tax rates; and the elimination of the estate tax. Lots of oxen stand to be gored or fattened, which will make passage of the package a challenge, as the failure of the Obamacare “repeal and replace” effort showed. And that’s before having to pass a fiscal-2018 budget resolution—a hurdle in itself and a necessary precursor of tax reform—using the reconciliation process, which requires a simple majority in the Senate, rather than 60 votes. From the standpoint of the stock market, the key change would be a cut in the corporate maximum tax rate to 20% from 35%, which would give a significant jolt to after-tax profits. For the big-cap companies of the Standard & Poor’s 500 index—which reached another record high last week—RBC Capital Markets estimates that a drop to 20% from their average effective rate of 27% would add $10.50 per share to earnings. (The current consensus 2018 forecast is $145, according to Bloomberg.) That would be worth around 200 points (or about 8%) for the S&P 500, based on a forward price/earnings multiple of 19 times, says RBC. Small-caps in the Russell 2000 index, which tend to pay a higher effective tax rate and thus would benefit more from a tax cut, also ended the week at a fresh record high. Part of the enthusiasm for equities reflected the repatriation prospects for profits that U.S. multinationals have earned abroad and have stashed there. But that stash effectively might be spent. As Peter Boockvar, the chief market analyst at the Lindsey Group, points out, these corporations have borrowed against that overseas cash to pay for share repurchases and dividends. Looking at four global tech megacaps, he finds that Apple (ticker: AAPL),Microsoft(MSFT),Oracle(ORCL), andCisco Systems(CSCO) collectively have added $168 billion to their balance sheets in the past three years, while increasing their debt by $174 billion. “Thus, one could argue much of their repatriation has been spoken for via the rise in debt, which was then used mostly for buybacks,” Boockvar writes in a client note. The optimism assumes the tax package will pass in something resembling its current form. Libby Cantrill, Pimco’s head of public policy, writes that governors and mayors have been lobbying GOP members of Congress from high-tax states over the proposed repeal of the state and local tax deduction. The pleas are coming not just from high-income-tax California and New York, but also from Texas, which has high property taxes. Finally, fiscal stimulus would probably elicit a reaction from the Federal Reserve, especially with the economy at full employment by conventional measures. Press reports indicate that the White House is interviewing candidates to succeed Fed Chair Janet Yellen, whose term ends early next year. Bond yields rose last week on the prospect of less monetary accommodation. That could counter stock bulls’ tendency to count tax-cut chickens before they hatch. LAST WEEK’S DISCUSSION here about Berkshire Hathaway CEO Warren Buffett’s prediction ofDow 1,000,000in 100 years elicited some lively comments (as well as carping;see this week’s Mailbag). That seemingly outlandish target actually represents a relatively modest annual price appreciation of just under 4% (not including dividends). But, as noted here, that may prove to be overly ambitious, given a relatively slow-growing economy owing to little or no expansion of the labor force because of a declining fertility rate, combined with lagging productivity gains. It’s safe to say that none of us will be around in 2117 to find out who was right, given Keynes’ dictum about the long run. But over the not-quite-so-long term of the next decade or so, U.S. stocks’ prospects are decidedly less positive. That’s based on the current equity market, whose heady valuation has essentially taken away from future gains, while also increasing the risk of “drawdowns,” as sudden declines are called in the lingo of institutional money managers. That’s the nonconsensus view of two prominent members of that cadre, Guggenheim Investments and Russell Investments. Their message: U.S. stocks aren’t the place to be in the next several years, which means that investors should set their sights elsewhere in the world. Excess valuations are a lousy reason to sell, as Guggenheim’s Brian Smedley and Matt Bush admit. “After all, markets that are overvalued and become even more overvalued are called bull markets,” they write. But, they note, “over a relatively long time horizon, valuation has been an excellent predictor of future performance.” High valuations typically mean that future gains have been pulled forward, which they attribute, in part, to the “extraordinary monetary policy” of recent years. In the wake of the financial crisis, the Fed and other central banks pushed short-term interest rates down to zero (and below that in Europe and Japan) and made huge asset purchases, helping stocks soar to records. Those heady valuations are less apparent in conventional measures such as price/earnings ratios, which are within norms at about 18 times forward earnings for the S&P 500. Compared with the U.S. economy and corporate earnings over the longer term, however, the valuations are more stretched. As a percentage of gross domestic product, the value of the U.S. equity market has topped the levels reached in 2007, the peak before the financial crisis, Smedley and Bush point out. The only time it was higher was during the heady dot-com daze of 1999-2000. And, Smedley and Bush add, this measure isn’t an outlier but is confirmed by other gauges, including the cyclically adjusted P/E ratio, dubbed CAPE, developed by Nobel laureate Robert Shiller of Yale University. CAPE compares the S&P 500 to “normal” corporate earnings (the 10-year average of trailing earnings, adjusted for inflation). CAPE has an advantage over traditional P/E ratios, according to Andrew Pease, global head of investment strategy at Russell. The latter will seem “artificially cheap” relative to cyclical peak earnings, and expensive relative to depressed earnings at cyclical troughs. To be sure, a criticism of CAPE is that it has found stocks to be expensive since the Reagan years, relative to its long-term average of 14.3 times, as calculated by Shiller going all the way back to 1880. The only exception was at the market’s post-crisis nadir in March 2009, which brought CAPE down to that long-term average. But CAPE now stands at just over 30 times, a level “reached only twice before; during the tech bubble of the 1990s and in the 1929 stock market boom,” Pease points out. That doesn’t mean a crash is imminent. But the stock-market-to-GDP ratio and CAPE both suggest weak returns from equities in the coming years. For instance, the Guggenheim team calculates, when market cap to GDP reaches the current level, returns from stocks over the subsequent decade are below the 10-year Treasury yield. Specifically, the team’s model suggests that annual returns from equities will be just 0.9%, versus the 2.2% on the 10-year note if held to maturity. This model gave similar signals during the internet boom of the 1990s and in 2006-07, following the housing bubble’s peak. As for CAPE, when it has exceeded 22 times, Russell’s Pease finds, the following three years’ return from stocks has been less than 5%. The risk of a drawdown also increases dramatically, with an average drop of 21%, which meets the standard definition of a bear market. This suggests an “asymmetry” in the U.S. stock market, with greater risk than potential reward. The Guggenheim and Russell strategists conclude that the lackluster longer-term outlook for U.S. stocks means that investors should prospect for equities in Europe, Japan, and emerging markets. In fixed income, Pease prefers emerging market debt denominated in local currencies, while underweighting high-yield credits, again because of valuations. The Guggenheim team recommends focusing on sectors not included in the broad benchmarks, such as the Bloomberg Barclays Aggregate Index. That would include commercial asset-backed securities and collateralized loan obligations, which they say offer higher yields with less interest-rate risk than comparably rated corporate bonds. Maybe Buffett will be right in the next century. But for those needing to generate investment returns within their lifetimes, the valuations of the U.S. stock market suggest that it may not treat them as well as it has the Oracle of Omaha. Luckily, there are more alternatives than ever before. http://www.barrons.com/articles/wall-street-counting-its-tax-cut-chickens-early-1506744079