In this article, I will discuss the critical lever which will determine where the stock market will go in the next 3 months. There is a big difference between survey data and hard data. When the survey data initially improved in December, I was skeptical of it because of the size of the pop. For the most part, surveys have remained strong which makes me trust them more. It’s arrogant of me to assume the optimism is wrong just because the hard data hasn’t popped as much. There still hasn’t been legislation on tax reform or health care reform, but that doesn’t mean it won’t occur and boost the hard data. The tax reform will come first, later this year. I have circled on my calendar President Trump’s address to a joint session of Congress on February 28th as an important measure of where tax reform is headed. The President has stated tax reform is ahead of schedule, but, unlike his stances on other issues, he hasn’t give an update on where he stands on the boarder adjusted tax.
The chart below does a great job at explaining my point about how hard data hasn’t caught up with survey data. The hard data used in this chart is housing, production, labor, personal, and retail which gives you a large swath of the economy. The red line in the middle of the series, which represents the overall data, is increasing. I think it’s fair to say the first half of 2016 was the weakest economy in this recovery. It’s why the economy only grew at a 1.6% rate in 2016. If you look closely, the overall data almost fell to the trough set in 2009. Since then the economy has recovered.
The chart below shows the difference between survey data surprises and hard data surprises. The survey data is anticipating the fastest growth of the recovery occurring in 2017. The January ISM Manufacturing data has the GDP growing at 4%. I think it’s fair to say the survey data is anticipating between 4% to 4.5% growth for the year. The overall hard data has growth of about 2% to 2.5% which would be consistent with the trajectory this weak recovery has been on. Clearly the stock market is betting on the former path as the S&P 500 is now up 5.02% for the year. It has almost achieved the average returns for a year in 7 weeks.
The bears are using the difference between the hard data and the survey data to conclude the market is too excited. The chart below indicates when both the survey data has gotten ahead of hard data and the percentage of bulls is above 53%. Essentially, this is a chart of when survey data is improving and the market believes it is reflecting the truth. It has usually indicated when stocks are priced too aggressively as corrections have occurred after the arrows are shown in the chart. However, the question as to whether the hope is accurate now depends on whether the political reforms meet expectations.
While I have argued that regulatory reforms are more important to long term productivity growth than tax reform, I think the success of tax reforms being passed by Congress acts as a positive signal that the government is on track to improve business conditions. It seems likely that something will get passed by the end of the year since the GOP holds all branches of government. The devil is in the details.
The big hurdle for tax reform remains whether the boarder adjusted tax is included in the bill. There are Congress people on both sides of the discussion. The problem with listening to them about whether the bill will get passed is they are biased. Anyone who supports the boarder adjusted tax will say it has enough votes to pass and anyone who opposes it will say it doesn’t have the votes to reach the President’s desk. Steve Bannon, the White House’s chief strategist, and Paul Ryan, the Speaker of the House, support the boarder adjusted tax. Gary Cohn, the chief economic advisor to the President, opposes the tax.
Goldman Sachs has said there is a 20% chance of the boarder adjusted being enacted into law. After listening to some of the arguments made by both sides, I think the odds are higher than 20%. I would put it at 50%. The reason for my judgement is those arguing for the tax claim there is no other way to pay for the tax cuts. The House bill cuts the corporate tax rate to 20%. The boarder adjusted tax pays for the $1 trillion gap in the plan. It is a consumption tax. Some say the World Trade Organization may strike it down, but I don’t see that happening. Trump has already railed against these intergovernmental organizations, so he may threaten to leave it. It’s an implicit threat which may make the WTO cautious about trying to stop the American tax plan.
The counter side of this debate which argues against the boarder adjusted tax doesn’t have an answer as to how this tax will be paid for without it. The two responses are to cut the corporate tax rate less or to not pay for the tax cuts at all. If the corporate tax rate is lowered to 25% instead of 20%, it’s debatable if that counts as a tax cut as the S&P 500 already pays an average effective tax rate of 25%. Trump originally had a 15% rate in his plans, so a 25% rate would be a big compromise. It would mainly be a tax cut for small businesses that pay the 35% marginal corporate tax rate. Not paying for the tax cut is a mistake the GOP made under George W. Bush’s presidency. It makes the GOP look disingenuous as they complain President Obama ballooned the debt, but then they do the same thing by cutting taxes without paying for them. Another problem with the Bush tax cuts is they were only in effect for 10 years. The GOP doesn’t want these tax cuts to expire.
Conclusion
I am optimistic that the tax reforms will meet the market’s expectations. I think a tax cut could have similar positive GDP effects that the Bush cuts had in 2003. Q3 2003 GDP grew 7.0% and Q4 2003 GDP grew 5.5% because of tax cuts. I see the stock market falling 10% if the plan isn’t passed and remaining steady if it is passed. The key date is Trump’s speech to Congress on February 28th. Whichever plan he supports will likely get the support of Congress. Maybe the boarder adjusted tax plan having a higher chance of being passed is why the dollar has rallied recently as you can see in the chart below.
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