How Trump’s tax cuts and deregulation could fuel stocks … get ready for FOMO to add to the gains … how high we might go … but don’t forget: safety first
Suddenly, the upside potential for stocks over the next 12 months has jumped.
To explain why, let’s start with the two factors that drive a stock’s price: earnings, and how much investors are willing to pay for those earnings (which is a proxy for investor sentiment). These are the variables behind investing’s most common valuation metric, the price-to-earnings ratio (PE).
Over the last year, regular Digest readers have seen me highlight all sorts of valuation indicators that suggest investor sentiment has been the primary driver of stock market gains in recent quarters, not earnings.
I’ve argued that if we want this bull market to be with us for a long time, then at some point, today’s elevated valuations need the support of higher earnings. That would take pressure off nosebleed valuations that have been run up by sentiment.
Without greater earnings, stock prices are at risk of falling if investors begin to believe that they’re paying too much for too few earnings, causing them to sell stocks.
So, why do stocks suddenly have far greater upside potential?
Trump.
Specifically, his plans to cut corporate taxes and deregulate.
A fatter bottom line overnight
It isn’t a lock, but with Trump in the White House, Republican control in the Senate, and the likelihood of Republican control of the House, Trump should be able to push through his proposal to lower corporate taxes from 21% to 15%.
So, without even selling one extra widget, corporate profits would climb.
Here’s The Wall Street Journal with some context and forecasts:
In 2018, after Trump’s first round of tax reductions came into effect, the S&P 500’s earnings-per-share, or EPS, jumped by 21%, compared with an 11% increase the previous year…
Some Wall Street analysts think a new wave of tax cuts could boost EPS somewhere between 5% and 10%.
Meanwhile, deregulation could be an even bigger tailwind for earnings and growth.
Many CEOs will tell you that between high taxes and burdensome regulation, the greater evil is burdensome regulation.
For example, here’s Insights from the Stanford Business School back in 2017:
Jamie Dimon, the longtime chairman and CEO of JP Morgan Chase… told an audience that inappropriate regulation and burdensome taxation has cut U.S. GDP growth in half…
Companies prefer to do business overseas because “it’s so much more advantageous to do stuff over there.”
Millions of small businesses were never formed, Dimon says, because government policies stood in the way.
Tesla CEO Elon Musk has said “excessive regulation is like taking a bunch of rocks and putting them in your backpack.”
As to the fallout from excessive regulation, we can look to Europe. A few months ago, Ericsson CEO Börje Ekholm said that regulation “is driving Europe to last place [and] is driving Europe to irrelevance.”
With this as our background, here’s the AP News:
The president-elect seeks to reduce the role of federal bureaucrats and regulations across economic sectors. Trump frames all regulatory cuts as an economic magic wand.
He pledges precipitous drops in U.S. households’ utility bills by removing obstacles to fossil fuel production… [He also] promises to unleash housing construction by cutting regulations…and also says he would end “frivolous litigation from the environmental extremists.”
And here’s Thomson Reuters:
The regulatory landscape under Trump is also expected to see significant shifts. Deregulation would be a key theme, affecting sectors from energy to finance.
Bottom line: Fewer regulations are inherently profit-accretive for corporate America either by reducing compliance expense or by enabling greater revenue streams due to a freer market.
In both cases, it’s likely to result in higher earnings per share, which raises the ceiling for market returns.
Now consider the other half of the price equation – sentiment
In the wake of Trump’s win, investors are catapulting into “risk on” mode. This means selling bonds and cannonballing into stocks.
Yesterday, on an internal Slack channel, Lucas Downey, a quant specialist who works closely with Jason Bodner at our corporate partner TradeSmith, offered some perspective on the post-Trump-win rally:
Yesterday’s mega rally saw some of the largest inflows ever in our data.
486 equities were accumulated, that’s the 5th highest buy day ever going back to 2009. Below shows recent prior thrust days:
Now, think about all the asset managers who had nervous clients hiding out in bonds. Think about all the nervous investors who had their own money in cash.
With Trump’s win and the likelihood of lower corporate taxes, reduced regulation, heavy government spending, and a potential resurgence of inflation, are those asset managers going to want to keep their clients in bonds? Not if they want to keep their jobs.
Are those nervous investors going to want to stay in cash? Not if they want to keep up with the Jones’.
I can’t recall where I heard it, but there’s an old market saying that goes something like, “the only thing that investors hate more than underperforming the market is underperforming their neighbor.”
Though the market needs a pullback to digest this week’s monster rally, don’t bet against a roaring, FOMO-based stampede into stocks as we push toward Christmas.
Despite the potential for a melt-up, let’s not be foolish…
As we’ve stressed repeatedly here in the Digest, an emphasis on defense is far more important for growing your wealth than a focus on offense. But don’t take it from me. Here’s what a few pros have said over the years:
- Charles Ellis: “If you avoid large losses with a strong defense, the winnings will have every opportunity to take care of themselves.”
- Benjamin Graham: “The essence of investment management is the management of risks, not the management of returns.”
- Paul Tudor Jones: “Don’t focus on making money; focus on protecting what you have.”
So, what’s the risk to a Trump-fueled melt-up?
Interest rates/Treasury yields.
On Wednesday, our tech expert Luke Lango provided a 10-point guideline for what’s likely to play out for the markets under Trump’s second term.
Though Luke is bullish, he points toward the 10-year Treasury yield as the biggest wild card that could limit market gains.
From Luke:
The path forward for interest rates and Treasury yields seems uncertain, as it will hinge largely upon inflation levels over the next few quarters.
If Trump’s pro-economic and protectionist policies do create more inflation, which seems likely, then interest rates will not decline as much as the market expects… We will likely only get two or three cuts, and Treasury yields will rise…
If inflation rises and interest rates stay high, valuation multiples on the S&P 500 will compress, limiting upside in stocks.
This idea of “compressing valuation multiples” is the technical term for what I described earlier when I wrote, “Stock prices are at risk of falling if investors begin to believe that they’re paying too much for too few earnings, causing them to sell stocks.”
Luke sees the key issue being the 10-year Treasury yield:
If Treasury yields stay at or below 4.5%, stock multiples can expand and drive additional upside in stocks (beyond earnings growth).
But if yields climb toward and potentially even above 5%, multiple compression will limit gains.
This economic dynamic is arguably the most important of Trump’s presidency. And as of now, it’s unclear how it will play out.
As I write Friday, the 10-year Treasury yield is easing back. After having climbed as high as 4.47% earlier in the week, it’s down to 4.27% as I write mid-morning.
This is what we want to see.
So, for now, optimistic stock investors are positioning themselves for a boom
As to what that “boom” might look like, Luke believes 30% gains over the next two years are on the table, possibly 40%.
But for this to happen, there’s a clear progression:
Trump’s spending, tax cuts, and deregulation must not reignite inflation… the Fed must proceed with four-plus interest rate cuts over the coming months… and the 10-year Treasury yield must stay under 4.50% (and the lower, the better).
But if all this comes to pass, stocks are likely to make investors a boatload of money over the coming quarters.
Yes, be wise about what’s in your portfolio. Yes, protect your wealth with stop-losses and appropriate position-sizes. And yes, take the time to create an overall investment plan.
But with those steps in place, stay with this momentum. After all, there are new, genuine reasons to believe this bull market just got a fresh wind.
Have a good evening,
Jeff Remsburg
