Is the Bull Coming Back? – July 27, 2018

Dear Valued Clients and Friends,

The market moved further to the upside this week, within 1,000 points of its all-time high as of the closing level Wednesday, and nearly 2,000 points higher than its March low.  This quarterly earnings season has gone quite well, as expected, and various aspects of the trade trauma have begun to ease.  We need to look at inflation this week, some “new tax reform” possibilities, and more.  So jump on in, to this week’s Dividend Café …

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Tax Reform Part Deux?

This is something I intend to talk about more and more, because first of all, no one else is, and second of all, I believe it is real, substantive, and because no one else is talking about it, not at all priced in the market.  No, I do not see it happening before the midterm elections, but there are several key tax bill supplements that have potential market implications.

(1) I already wrote about the possibility of the Treasury Department issuing guidelines that would index the capital gain in a gain transaction to inflation.  This is a big deal for long-term stockholders.

(2) I expect that the House will move to make the individual cuts portion of tax reform permanent (they presently expire at the end of 2025).

(3) I am reading that there are new incentives for retirement savings coming but I have not read any details around these initiatives.

(4) There are also efforts underway to increase the Research and Development Tax Credit (though this is not one that gets me excited; I have never understood why companies should be paid, to do what companies do at the very core of their business).

Bottom line – potential tax legislation worked on over the months ahead with a vision to implement after the mid-term elections is something we will be watching closely in the months ahead.

The Inflation Chatter

I am in the camp that believed entering this year “chatter about inflation” would be on the rise, and I certainly believed (and believe) that there are market implications to rising chatter.  But that is a very different thing from core inflation being high, let alone staying high, for any extended period of time.  The very modest increase we see in the data this year comes off the Fed’s kitchen sink of efforts to make it so, and even then, mostly with transitory help.  Longer-bond yields (10-year and 30-year treasuries, for example) still suggest very muted long-term inflation.  The barrage of discussion about a shortage of skill-based workers has not seen wage growth skyrocket (Phillips Curve logic = dead).

My belief is that many of the data points being used to talk up inflation will prove to be drivers of increased productivity – not inflation.  Business investment and capex can be thought of as “soaking up” some of the inflationary potential, should they surface the way we forecast they will.

Contrarian Nugget for the Week

More than $20 billion was pulled from U.S. stock mutual funds and ETF’s in June (net), leading to one of the worst (or best?) periods over the first half of 2018 for equity flows in the last decade!  The huge flows out in June may explain the market’s huge up-performance in July.  $80 billion as flown into bond funds in the last six months.  History is a good guide here (1).

As profits go, so goes the market

The move higher in corporate profits is more impressive visually than it is in written form.  As the chart here indicates, we are at the highest level of corporate profitability, ever. And I would add – the period from mid-2014 through mid-2016 of muted profits growth coincides perfectly with a period of flat market returns.

A Real World Cup

The race for capital across the globe is a predictable one – what domiciles or geographies present the most attractive places to do business?  Where is growth likely to be found?  Where do companies want to put capital for an investment opportunity?  For all of the talk about a declining United States, a talk rooted in a lot of things, but not coherence or facts, there is surely no place investors have wanted to park capital more than the United States for a long time.  What levers can competitive countries pull to increase their standings in the race for global capital?  Lower taxes are at the top of that list.  The U.S. upped the ante with its tax bill late last year.  If you want to see the seriousness of countries trying to stand out as a place for capital investment, watch for those countries creating greater competitiveness in their tax codes over the next 6-24 months.

The big bad yield curve

A 3-month treasury is 2%, a 2-year is 2.7%, and a 10-year is 2.96%.  The curve steepened a bit this week, but still sits flatter than many like.  The difference between the 10-year and the 30-year is negligible.  The Fed is watching.

Bahnsen Group’s, Trevor Cummings, joins the Advice and Insights Party!

Check out Trevor’s inaugural Thoughts on Money blog here!!  THOUGHTSONMONEY.COM

Politics & Money: Beltway Bulls and Bears

  • The President met with Jean-Claude Juncker, the president of the European Union Commission, Wednesday.  Reports of progress in negotiation, and a mutual intent to reduce tariffs, not add new ones, caused a late-day rally in stocks.  Ultimately, if President Trump were actually to go forward with auto tariffs on European imports to the U.S., a significant amount of the benefits of tax reform in our economy would be eaten away.  The total implemented tariffs so far are under $10 billion; the proposed tariffs on the table are at $60 billion; these EU auto tariffs would add another $73 billion of detraction from the economy.  The idea of getting to a zero tariff on industrial goods is a big positive, and they have agreed to no new tariffs while final negotiations continue.
  • The President’s proposed $12-14 billion farmer aid program which came out this week implicitly shows the President’s awareness of the negative fiscal impact his trade war is having on the very constituencies he most promised to protect.  While I find the policy horrifying, I am relieved that at least it speaks to the reality of how severe these tariffs hurt Americans.  It is an ironic view, but I essentially take it to mean that he knows differently than he says (about how great tariffs are).
  • The trade issues with Europe seem to have taken a turn for the better this week, but the same cannot yet be said about China.  And with China’s stunning refusal to approve the Qualcomm/NXP deal, there are ample reasons to believe this could get worse before it gets better.  And of course, even in Europe, until a final deal is reached, the situation can hardly be called “settled.”

Chart of the Week

One of the most consistent themes in financial market discussions is that of “valuation” (including in our own process and deliberation).  This week’s Chart of the Week shows the reality of the present market levels (not cheap, not expensive) – but I will add – it does not reflect one of the most important facts in the overall market valuation …  And that is, the blended S&P valuation is deeply impacted by the valuation of its largest 5-10 names, some of which create a huge and disproportionate impact on total valuation.  In other words, if the overall market is in an average valuation, and its heaviest constituents are quite over-valued, it stands to reason that there are a lot of under-priced companies in the market universe.

Quote of the Week

“The stock market is the only market where things go on sale and all the customers run out of the store.”

~ Cullen Roche

* * *
We await the end of July next week and look forward to what August brings.  I am reminded that it is just another summer weekend and that sooner than later, summer will be gone.  So enjoy the time with your friends and family, and I will try to do the same.  Markets will be there Monday morning.  They always are.

With regards,

David L. Bahnsen
Chief Investment Officer, Managing Partner

The Bahnsen Group
(1) Wall Street Journal, July 26, 2018


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About the Author

David L. Bahnsen

David is a frequent guest on CNBC, Bloomberg, and Fox Business and is a regular contributor to National Review and Forbes. David serves on the Board of Directors for the National Review Institute and is a founding Trustee for Pacifica Christian High School of Orange County.

He is the author of the books, Crisis of Responsibility: Our Cultural Addiction to Blame and How You Can Cure It (Post Hill Press), The Case for Dividend Growth: Investing in a Post-Crisis World (Post Hill Press) and his latest, Elizabeth Warren: How Her Presidency Would Destroy the Middle Class and the American Dream (2020).


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