C.J. Lawrence // Blog
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27 Sep C.J. Lawrence Weekly – “The Prospect for Corporate Tax Reform May Be Keeping Bears in Their Dens”

The Prospect for Corporate Tax Reform May Be Keeping Bears in Their Dens

Senator John McCain’s indication that he would not support the Graham-Cassidy Health Care Bill threw more sand into
Washington D.C.’s gears last week. Week-end jockeying may make the bill more palatable to hold-outs, but the machinations
highlight the fact any new legislation faces considerable challenges in making its way through the current congress. Tax
reform looks to be next on the docket, with many Beltway watchers suggesting that corporate tax reform has a better chance of
success than individual income tax reform.

With top marginal corporate tax rates nearing 40%, KPMG lists the United States as having the highest corporate tax rates
globally, among developed countries. Of course, there are nuances in the comparisons, but there appears to be consensus,
even in Washington, that U.S. corporate rates need to be reduced. The timing of legislation is unclear, with most policy
analysts suggesting that 1Q18 or 2Q18 is most likely. We may see a framework for the legislation released this week.

The President has suggested the new corporate rate should be near 15%. While it is unlikely that new legislation will go that
far, even a reduction to 25% would have a meaningful impact on corporate profits. Roughly 70% of S&P 500 constituent
revenue comes from domestic sources. That ratio is higher in U.S. focused sectors like Telecom (96.2%) and Utilities (95.3%),
and lower in global sectors like Materials (53.1%) and Energy (57.6%). For the broader index, if U.S. pre-tax income was taxed
at a 25% rate, instead of the current 33% effective rate, the index could see a ~7.5% boost to net income. That would put S&P
500 EPS estimates (assuming a static share count) for 2018 slightly above $155. Under this scenario, earnings would be up 19%
in 2018 and the current price-earnings multiple on the index would be 16x 2018 estimates. That is a constructive backdrop for
stocks. The prospect of corporate tax reform may encourage hibernating bears to stay in their dens.

25 Sep C.J. Lawrence Weekly – “Inflation & the Rule of 20” – September 18, 2017

Higher gas prices and housing costs helped push last month’s Consumer Price Index (CPI) reading to 0.4%, versus the 0.3% most economists were expecting.  Interestingly, it was the medical cost category that restrained the index, growing at the slowest pace since 1965, according to the U.S. Bureau of Labor Statistics.  The higher-than-expected result helped raise the annual CPI rate to 1.9%.  That was welcome news for inflation seekers, but domestic inflation remains at historically low levels and below the Federal Reserve’s 2.0% target.  The U.S. 10-Year Treasury Bond responded to the report by tacking on 15 basis points of yield, finishing the week at 2.20%.

The rate of inflation is watched closely by equity investors.  In the early 1980’s, C.J. Lawrence Investment Strategist, and our current Chairman, Jim Moltz, pioneered the CJL Rule of 20 as a measuring stick for the relationship between the market multiple and inflation.  The simple calculation behind the Rule suggested that the sum of the S&P 500 price-earnings multiple and the annual rate of inflation should equal about 20.  The premise suggested that so long as inflation remains tame, the market multiple can climb and remain elevated.  Using Factset consensus S&P 500 earnings per share forecasts of $131 for 2017, and $145 for 2018, and a 2.0% CPI estimate, puts the current reading between 21.2 and 19.3, with a midpoint of 20.3.  That sounds about right.

The current result suggests that the market is certainly not undervalued, but that the valuation is also not stretched beyond historical norms.  In 25 out of the last 50 years, the ratio has held between 19 and 22.  Out of those 25 periods, only three experienced negative equity returns.  Two of those periods were the 1973-1974 period when the S&P 500 returned -14% and -37% consecutively in the bear market of the early 1970’s.  The other negative return period was 2008, at the onset of the credit crisis and subsequent recession.  The average return for the full 25 periods was 9.5%.  There are plenty of risks to equity prices, but the current market multiple, given the historical relationship with inflation, does not look to be close to the top of the list.

24 Feb Inflating European Expectations

The Wall Street Journal reported yesterday that for the first time in almost 4 years none of the Eurozone’s 19 member countries was in deflation during January.  Aggregate Inflation across the region is now 1.8%, approaching the ECB’s target of 2.0%.  The data is a notable marker that may be the signal for the ultra-accommodative ECB to reign in its QE program a little over two years since the Fed ended QE3 in the fall of 2015.  Such a move would have a profound effect on European currency rates with the U.S.  Fund flows follow real interest rates over the long-term.  With real interest rates higher in the U.S. than almost any Developed economy it is a no brainer that money should flow into the dollar.  As the fed began raising rates at the end of 2015 it is no surprise that European currencies correspondingly declined substantially over the course of last year. The Fed’s most recent hike has put further pressure on the value of GBP, EURO, CHF and Kroners. 

Enter the natural beauty of self-correcting global economics.  Between 2011 and 2015 global fx markets were mind numbingly boring.  During, what on the surface, appeared as a turbulent period in global economic history Sterling and the Euro traded within a very narrow range with the USD.   With virtually all central banks aligned behind hugely stimulate actions, transatlantic currencies traded largely in unison.  In such circumstances with the US ahead of the curve in terms of post crisis economic recovery the competitive advantage lay in North America.  The turn in Fed policy at the end of 2015 broke that trend and 2016 served as a corrective year in terms of currency equalization. 

The downdraft in European currency valuations has had the twin effect of boosting Europe’s competitive position and pushing up inflation as import prices increased.  European markets have quietly taken note.  Despite European equity performance in dollar terms once again falling behind U.S. in 2016, in local terms European equities had a strong year with aggregate performance reaching high single digits.  For U.S. based investors the benefits of increasing exposure to Europe are sweetened by the weak currencies and the opportunity to shop around for stock at attractive discounts.  Wow, even a Big Mac in London is now 6% cheaper than the U.S., in London! 

In the post crisis-era international markets have morphed into risk-on trades.  Despite positive U.S. based market returns, investors have remained jittery in recent years preferring assurance over risk.  As global economic growth increases and a reflation trade gets underway the irony of a successful Trump economy could very likely be that international markets begin to outperform as risk appetite re-emerges and investors seek higher returns at reasonable valuations–sounds like Europe to me.