Richard Suvak, MSF, CFA
As details of President Trump’s tax policy proposal have become known, I thought it the right time to consider the impact his proposal may have on the economy writ large as well as for the S&P 500 specifically. In particular, I consider the benefits lower taxes will have on economic and earnings growth in relation to an expensive market.
When considering tax policy, the potential upside to lower taxes seems obvious. The supply-side theory suggests lower taxes equate to higher after-tax income and therefore more cash available to be spent. As a result of this additional money supply (extra spending power), individuals and businesses will spend more, leading to higher overall economic growth, increased availability of jobs (to handle the additional business created by higher spending) and increased personal and corporate earnings. The expense of lower tax receipts received from these lower tax rates is believed to be paid for by higher economic growth.
On the other hand, the potential downside is also obvious. Extra spending power means prices are subject to inflation. After all, if you have an extra dollar in your wallet due to lower taxes, paying a bit more at the grocery store still leaves you ahead. Detractors will also point to an imbalance of benefits between high earning tax payers and those who earn less, an overall reduction in tax receipts, expansion of the deficit and growth of the national debt.
Unfortunately for supporters and detractors of a tax reduction plan, both arguments are true. What’s missing in the debate is whether we have the most efficient tax policy possible. I.e., are we incentivizing individuals and businesses to maximize output, and is that even the right goal. Tax debate seems forever lost in the political barrage of half-truths lobbed from one side to the other.
Rather than speculate and add more hyperbole to the subject, this article attempts to examine the history of tax policy on the economy and S&P 500. It then attempts to bridge the gap between the impact of the current proposal and the growth required to justify the current high valuations of the market. More than any other campaign promise, investors have been anticipating this part of Trump’s Presidency more than the others, and have bid the market higher in expectation of passage. But is it enough? Has the market gone too far? Or, can we expect more? I attempt to answer these questions as I use this information to inform Eunoia’s investment strategy, particularly in the current expensive market environment.
Historic Tax Rates
Rather than wade through the muddy waters of different tax brackets, the myriad list of deductions, complicated depreciation schedules and a whole host of other tax savings strategies, I have used the effective tax rate for my calculations. Effective tax rates are actual tax payments divided by income. It is the rate of what you actually pay after using every loophole available to you. Specifically, it is not the headline or marginal rate often quoted in the news or by your tax accountant. In the charts below, we can see that effective corporate tax rates have trended downward since 1947 while individual tax rates have remained relatively constant since 1979, albeit with a somewhat wider, and lower, rate for lower income earners.
By way of comparison, Trump’s plan calls for:
Without specific details it’s impossible to know the net effect of lower taxes and elimination of deductions, but let’s assume it will be a net gain for tax payers.
Influence of Tax Rate on Economy
Regardless of the net rate, the important consideration when raising or lowering rates is the influence the new rate will have on the economy. This is the bang-for-the-buck part of the analysis. In other words, what will the influence on the economy be from a lower tax rate for individuals, corporations and the combination. Using the chart below, we can see that personal income represents 60-70% of National Income in the US while corporate profits and non-farm income (effectively small businesses) represents roughly 15-25% of National Income. As you would expect, there are more workers than there are businesses, and collectively we represent a bigger portion of the economy. However, this does not suggest that business income, and therefore tax receipts, represents less than half the impact of personal income. On the contrary, collectively, businesses employ and pay those earning personal income. Individuals and businesses are two halves of the same apple.
Assuming businesses will continue on, and we don’t revert to growing and harvesting our own food, the next concept to understand is the multiplier effect. Often used in reference to bank reserve policy, the same concept applies to expanding personal or business incomes due to lower taxes. That is, banks are required to keep only a small portion of deposits in their banks at any given time. Historically, this has ranged from 6-10% and depends on the type of assets. In the simplest example, for every $1 of additional deposit, a bank can lend out $0.90-0.94 as mortgages, business loans, car loans, etc. Therefore, a bank grows by attracting more deposits, which it can then lend to others. For the most part, bank earnings are the difference between what it charges to borrow money and what it pays to its depositors. In bank-speak, this is net-interest margin. When considering tax policy, the same concept applies. Ignoring fairness issues for the moment, the amount of the additional income received (via lower tax rates) which is spent, will determine the growth rate of the economy due to the tax cuts (or vice versa). Collectively, if we receive an extra $1 of after-tax income due to lower taxes, and spend 100% of that dollar, we will grow the economy by $1 times the number of workers on day one. Because that full dollar has been spent, and received as income by businesses, which are taxed at a lower rate, that dollar (or the after-tax portion of the 2^{nd} transaction) can be spent again… and again… and again. One additional dollar in after-tax income can quickly turn into many dollars – the multiplier effect in a nutshell.
An outstanding question for economists is correctly predicting the multiplier effect. In essence they are trying to figure out the circumstances where individuals and businesses will spend a greater portion of savings versus those times when we will put it under the mattress. The answer to this question is key to everything that happens after a tax cut. Frankly, I don’t have the answer, and neither do they. However, let’s assume that whatever the multiplier is, it will be positive. We will spend some portion of the additional money we receive after the new, lower tax rate is implemented. The more we (individuals and businesses) spend, the higher the impact on economic growth and corporate earnings (using the S&P 500 as a proxy).
Knowing the impact of tax rate policy on economic growth leads us back in time. The two scatter plots below show historic corporate (left) and individual (right) yearly changes in effective tax rates relative to nominal GDP growth, lagged by two years. The lag is introduced so that we can see the full effect the change in the tax rate has on GDP growth. Statistically speaking, there is very little impact on GDP growth regardless of the change in corporate or individual tax rates. In point of fact, there is a slight positive impact (higher taxes lead to higher economic growth).
However, nominal GDP growth includes inflation. So, do changes in tax rates influence inflation? To answer that question, I present the following charts which graph yearly corporate and individual tax rate changes relative to real GDP growth (lagged two years) as well as relative to implied inflation (the difference between nominal and real). As we can see from these charts, reduced corporate and individual taxes rates have a (moderate) positive influence on real GDP growth. However, lower corporate rates raise inflation while higher individual rates raise inflation.
Using the charts above, it’s fair to conclude that lower tax rates, both corporate and individual, will have some effect on overall economic growth. How much remains unknown and is a subject for more advanced economists to debate. Nonetheless, directionally, lower tax rates are good for economic growth.
Influence of Tax Rates on S&P 500 Earnings Growth
Turning our attention to the market, we’re interested in knowing whether the investors who have bid-up the S&P 500 in anticipation of a tax cut are correct to expect higher earnings as a result. While the above broad economic analysis would suggest so, do the results trickle down into corporate earnings? Overlaying nominal and real earnings of the S&P 500 onto our earlier chart of effective corporate tax rates yields the below. Visually, ignoring the periods of volatility surrounding the bursting of the Y2K bubble in the late 1990’s and mortgage bubble in 2008, it suggests lower rates equates to higher earnings growth.
Using scatter plot charts (below), we can in fact see that this is true. Changes in effective corporate tax rates leads to higher S&P 500 earnings growth, both nominal and real. Further, by a factor of more than four, change in tax rates have a significant impact on corporate earnings growth. For example, a 5% reduction in the effective corporate tax rate, leads to an approximately 20% gain in corporate earnings growth. As my kids would say, boom shakalaka!
S&P 500 Valuation
From previous writings, we know that equity markets (represented by the S&P 500) are expensive relative to history. Depending on who you talk to, there are various reasons, and justifications, for that being the case. Many say, as I do, that investors have bid up the prices of the market in expectation of higher earnings growth. This additional growth, the argument goes, is that Trump’s campaign promises of lower taxes and lower regulation will lead to lower expenses and therefore higher after-tax income. Many others suggest that the current prices are not historically high given the low interest rate environment we also enjoy. I believe this is also true. Still others offer various nonsensical arguments about new regimes, high cash balances, high investor fear and low volatility. They use facts, figures and charts to make their case but they often lack the one component necessary when making investment decisions – causality.
The chart below shows the impact interest rates have on valuation. The green line is the 10-year constant maturity Treasury rate. The blue, the P/E of the S&P 500. The colored straight lines indicate the different interest rates environments we have seen since 1871 (gentle decline or relatively flat, rising and falling). Those three periods correspond to similar, albeit opposite reactions, in the valuation of the market. During the long initial period of steady, and low, interest rates, market valuation was relatively constant. As interest rates rose in the late 1900’s, valuations fell in response. Once Fed Chairman Volcker broke the back of inflation, rates began to fall in response, and the equity markets responded with higher valuations.
To be as generous as possible, I have used the falling interest rate period for valuation purposes (since 1981). This is generous because using the entire history, or frankly including any additional historical data, makes valuation of the S&p 500 appear even more dire. Additionally, and this is important, one must decide which period we are in now. Can we make the case that interest rates will continue to decline from current levels? No reasonable person could draw that conclusion, particularly after the June rate hike by the Fed and expectations of another in December. If you don’t believe we are in a declining interest rate environment, can we expect to have flat (or relatively stable) interest rates? This is a more plausible argument, but one that requires a “Goldilocks” economy – high growth and low inflation. Possible, but very difficult to achieve. Nonetheless, we’ll proceed as if the impossible were to happen and we are in the falling interest rate environment.
Using the oft-quoted valuation measures of S&P 500 P/E and Shiller P/E ratios one can see from the above where current valuations (red dot) stand relative to our “best case” valuation history. In the straight P/E case, we are currently at the 76^{th} percentile, while the Shiller P/E is at the 88^{th} percentile. Meaning, in only 24% and 12% of the time respectively, have we seen higher valuations during our shortened history period. As a side note, both valuation methods are in the mid-ninetieth percentile if the full history is used. Valuation considered relative to interest rates, provides the following charts. Using these we can see that interest rates do indeed impact market valuation and that the current valuation (red dot) is at, or near, the high for the current rate of interest.
Despite using the most favorable valuation environment, (decreasing interest rates), market valuation is still high. Not as high as the peak of market bubbles or other extreme events, but high nonetheless. Again, we are giving valuation the benefit of the doubt. Were we to include the entire period, things would look much worse. However, given that valuations are high, what should our return expectations be? The two charts below provide a clue to how we should think about future returns. That is, as valuations become extended (moving from cheap quartile to expensive quartile or left to right along the x-axis below), future returns decrease. Using P/E, we should only expect 3.8% return over the next 12 months given the current valuation in the 76^{th} percentile, while using Shiller P/E, we should only expect 3.0% based on the current 88^{th} percentile current valuation. Likewise, over the next three years, we can expect 6.4% and 0.3% respectively (note that these returns are not annualized – that’s 0.3% over 3 years, or about 0.1% each year for the next 3 years).
No matter how you look at it, S&P 500 valuation looks questionable at best, and historically offers relatively paltry returns during similarly high valuation periods in the market’s history. Extending this to the full history makes things look even worse, but we’ll ignore that for the moment.
S&P 500 Earnings Growth
As the current market valuation is based on anticipated additional earnings growth, let’s take a look to see where we are there too. The two charts below show quartile bins of historic growth (again, using our shortened “Goldilocks” period) along with the most recent growth (red dot). In nominal terms, the most recent growth of the S&P 500 was 16.02% (representing the 68^{th} percentile of historic growth) while real growth was 13.32% (69^{th} percentile). Corporate growth, represented by the S&P 500, has worked its way out of the earnings contraction period caused by the global financial crisis to the beginning of respectable growth. The recent number, by the way, represent significant improvement upon earnings growth reported recently. For example, earnings growth as recently as one year ago was negative 13%. Regardless of whether Trump is successful in passing his tax proposal, it seems we are fully in recovery mode.
In opposition to valuations, high growth is better for future return expectations. As the charts below demonstrate, higher growth quartiles (those to the right) provide (generally) higher future returns historically speaking.
Therefore, regarding earnings growth, S&P 500 companies are growing faster than average and that growth has recently been accelerating. Where we end is anybody’s guess, and therefore valuations based on unknown growth are guesses as well.
S&P 500 Required Earnings Growth to Justify Valuations
The last piece of the puzzle brings together valuation and growth. From the above discussion we have seen that valuations are high (76^{th}-88^{th} percentile of the low interest rate, best case period) and that earnings growth is recovering and currently in the 68^{th}-69^{th} percentile. However, if we assume that interest rates will be increasing as is generally expected, valuations look to be stretched even further. Countering those high valuations however, Trump’s tax reduction proposals should result in additional economic growth and higher earnings growth for the S&P 500 (again, assuming the multiplier theory holds). So, is it the case that we have two opposing forces cancelling each other out, or does one dominate the other?
Rather than answer that question directly, we can reframe the question and answer the level of earnings growth required to justify the current market valuation. We do so by using simple algebra to reframe the price-to-earnings multiple so that we calculate the earnings growth which would bring the current valuation down to more “reasonable” numbers. That is, holding the S&P 500 price at 2,500, what would P/E and Shiller P/E values be given various earnings growth rates. The charts below answer that question.
For example, holding price constant (2,500) a P/E of 19.48 (representing the median of our best case period), earnings would need to grow by 28% from their current level. Likewise, earnings growth of 40% is required to bring the Shiller P/E back to the median of 21.96. However, if we’re not so stringent on our valuation requirements, growth of 16% brings us back to a P/E of 21.40 (65^{th} percentile) and growth of 21% back to a Shiller P/E of 25.41 (65^{th} percentile). A partial table of required earnings growth for historical P/E and Shiller P/E is below. Again, this table assumes the price of the S&P 500 remains constant and only earnings are growing or contracting for valuations to change. Which means, for valuations to revert to something a bit more “normalish”, earnings would need to grow AND prices would need to remain constant. In other words, returns would be 0%. The other options, of course, would be for prices to drop and earnings remain constant or some combination of the two. Mathematically, there’s no other way to get to lower valuations – earnings must grow, prices must drop or a bit of both must happen.
Percentile | P/E | Required Earnings Growth | Shiller P/E | Required Earnings Growth | |
50% | 19.48 | 28% | 21.96 | 40% | |
55% | 19.88 | 25% | 23.35 | 32% | |
60% | 20.56 | 21% | 24.64 | 25% | |
65% | 21.40 | 16% | 25.41 | 21% | |
70% | 23.21 | 7% | 25.92 | 19% | |
75% | 24.59 | 1% | 26.47 | 16% | |
80% | 25.55 | -2% | 26.98 | 14% | |
85% | 27.91 | -11% | 28.80 | 7% | |
90% | 32.29 | -23% | 32.59 | -6% |
However, the above assume that valuations should go lower. That doesn’t have to be the case. Valuations could go higher, but how much higher and for how much longer is it reasonable to expect? At some point we’re just moving from an expensive market to a bubble-territory market.
Conclusion
We can have reasonable certainty that Trump’s tax proposals (if enacted) would stimulate economic growth, and in particular, S&P 500 earnings growth. There are however a couple roadblocks in the path of future market gains. Those are:
Certainly, it’s fair to say that any reduction in taxes could prove the spark for unprecedented earnings growth, blowing any notion of an expensive market out of the water. The downside to that scenario is the likelihood that inflation comes along with it, leading to even higher interest rates.
Therefore, I believe, we are in a make-no-mistakes situation. If Trump’s tax proposal fails to pass, the anticipation built into the market becomes a backlash. If Trump’s tax proposal is passed, the Fed must walk the fine line of controlling inflation without increasing interest rates dramatically.
The question for investors is; which scenario makes the most sense?
Eunoia’s bet is Trump won’t get all of what he wants (if any of it), and if he does, the Fed won’t be able to stop increasing interest rates to ward off the after-effects of lower taxes (inflation). The odds of successfully walking this knife edge are about as close to zero as Eunoia can calculate.