Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

Month: March 2017

TAXATION MATTERS

Wisdom Tree, the seventh largest (by AUM) ETF provider, did a bottom up analysis of S&P companies to assess the potential earnings impact of an eventual tax reform. To summarize (their complete blog post is here):

  • The effective tax rate for the S&P 500—based on the last three years of data to smooth out some noise in profitability—was approximately 27.7%, whereas the effective tax rate for small caps was almost 32%.
  • We did simulations for what the new effective tax rate would be under both a 25% U.S. corporate tax rate as well as a 15% corporate tax rate that Trump has suggested wanting to implement.
  • For large caps, we estimated approximately 9.1% earnings growth that comes from reducing tax rates to 25% and double that earnings growth (18.2%) with a lowering of corporate tax rates to 15%.
  • For small caps, we estimated small-cap earnings growth of 11.6% with a reduction in tax rates to 25% and again double that rate to 23.1% with a reduction in corporate taxes to 15%.

25 Corp Tax Rate

15 Corp Tax Rate
Good but still incomplete assessment because there are likely to be many other tax measures that could change in the reform (e.g. interest expense, full capex deductions), not to mention the still possible BAT.

Nonetheless, let’s assume that Wisdom Tree’s numbers prove correct and that the reform is effective Jan. 1, 2017. Let’s then recalculate valuations with these new tax-reform adjusted estimates for 2017.

The S& P 500 EPS estimate goes from $131.00 to $143.96, +9.1% and the forward P/E declines from 18.1 to 16.5. The next 2 charts assume $144 in EPS.

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The Rule of 20 P/E would also decline, from 22.5 to 18.8 assuming $143.96 are trailing EPS, back into undervalued territory but only 6.0% below the “20” fair value.

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Note these potential caveats:

  • The reform may not happen, may not happen as expected, may not happen in 2017 and may not be effective Jan. 1, 2017.
  • The current 10% EPS growth rate expected in 2017 may be too high, especially with revenue growth seen at +5.3% and energy earnings seen tripling this year on the assumption that oil prices will average $60/bbl.
  • The U.S. economy is off to a slower start than originally expected.
  • Interest rates are rising and corporate America is heavily indebted.

Given all the above, the 6% valuation cushion appears insufficient to warrant higher risk exposure.

THE DAILY EDGE (14 March 2017)

Small Business Owners Still Optimistic

The Index of Small Business Optimism fell 0.6 points to 105.3, sustaining the remarkable surge in optimism that started November 9, 2016, the day after the election. Three of the 10 Index components posted a gain, six declined, all by just a few points, and one was unchanged. It is encouraging that the Index has held at 105 for three months now, and not faded. (…) Optimism has not faded, but the enthusiasm has yet to be translated into an equally impressive increase in spending and hiring.

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U.S. small-business owners are the most optimistic they have been since July 2007, according to the latest Wells Fargo/Gallup Small Business Index. The overall index is now at 100, up 20 points since November and up 33 points from one year ago. This represents the largest quarterly increase in three years.

Trend: Wells Fargo/Gallup Small Business Index

(…) Owners are usually more positive about the future than they are about present conditions, and that pattern holds in the latest update. However, the rise in the index from the fourth quarter of last year to the first quarter this year is mostly a function of owners’ increased optimism about current conditions, with the first-quarter score of 40 representing a 16-point jump since last quarter. This is as high as it has been since 2007, and is up nearly 70 points from its all-time low of -29 in the first quarter of 2010. The future expectations score of 60 is up four points from last quarter.

U.S. Small-Business Owners' Present Situation and Future Expectations

Owners’ overall ratings of their financial situation, cash flow and revenues improved this quarter:

  • Improved revenue: 45% of small-business owners said their revenues increased a little or a lot in the past 12 months — up from 37% in November.
  • Stronger cash flow: 64% indicated their cash flow over the past 12 months was very or somewhat good, up nine percentage points from 55% in November and the highest rating on this metric since the third quarter of 2007.
  • Overall financial situation: 71% said their overall financial situation is very or somewhat good — up from 66% in November and the highest percentage for this question since the fourth quarter of 2007, when 72% indicated this.
U.S. Employment Trends Index Marches to All-Time High

The trend in the U.S. labor market has never been stronger. The Conference Board said March 13 that its index of employment trends reached a record 131.39 in February. All of the gauge’s eight individual indicators — including a decrease in applications for jobless benefits and a smaller share of Americans saying jobs are hard to come by — contributed to the advance. “It seems that higher business confidence is carrying over to hiring,” Gad Levanon, the group’s chief economist, said in a statement.

US Producer Prices Spike At Fastest Rate In 5 Years
Mortgage Rates Approach 3-Year Highs Ahead of Fed

Mortgage rates rose for the 10th time in the past 11 days today, bringing them very close to highest levels in 3 years.  You’d have to go back to April 30th, 2014 to see the average lender offering higher rates.  The most common conventional 30yr fixed quote is easily up to 4.375% on top tier scenarios with a growing number of lenders moving up to 4.5%.

SENTIMENT WATCH
Price and Value Are Increasingly Distorted in Markets
Trouble ahead for PE investors?

Buried in the latest issue of Bain & Company’s Global Private Equity Report are a few concerning nuggets for investors.

First, buyout firms are paying extraordinarily high prices for their targets, even higher than during the last boom in 2007: (…)

From David Rosenberg:

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Stock buyback activity has declined recently, driven largely by the energy sector. Will we see significant improvements this year?

Source: Morgan Stanley, @MattGarrett3 via The Daily Shot

CBO Sees 24 Million More Uninsured, $337 Billion Deficit Cut With GOP Plan The number of Americans without health insurance would grow by 24 million under a House Republican proposal to topple most of the Affordable Care Act, according to a nonpartisan report that is likely to complicate GOP lawmakers’ efforts to unite around the plan.