The Devil’s in the Details: Tax Plan Unknowns Weigh on Stocks

Wall Street’s cherished goal of tax cuts is within grasp. But as investors chew over the details, they’re starting to get indigestion. Market enthusiasm waned on Tuesday, with all three major indices closing in the red.

As House and Senate versions of tax overhaul get reconciled in conference, inconvenient questions are emerging. The Trump tax plan would add $1.5 trillion to the national debt. Who pays for that? Eliminating deductions for the middle class won’t be enough. Popular government programs would need to get cut.

The Senate bill retains the corporate alternative minimum tax (AMT). The House repeals the AMT. Who wins that fight?

The Senate accidently killed all corporate tax deductions. As Homer Simpson would say: “D’oh!” Presumably, that’s not what the GOP-led Senate had in mind. That mistake needs to get fixed.

The list of unexpected complications goes on. Traders are happy that tax overhaul passed the House and Senate. But as they read the details, they’re getting nervous.

Hence the consequences of hastily writing a tax bill and then ramming it through in the dead of night even though most lawmakers have never read it. Just sayin’.

Who wins, who loses?

It’s not unprecedented for legislation to die in conference. That’s not gonna happen here. We’re almost certain to get a tax bill for President Trump’s signature. But investors aren’t sure right now who wins and who loses.

As Republicans grapple with revisions to reconcile the House and Senate versions of tax reform, expect greater market volatility in the days ahead.

When the dust settles, here’s the upshot: The corporate tax rate will get cut from 35% to 20%. That will boost earnings and in turn lift stocks.

Meanwhile, the market is undergoing rapid sector rotation. This phenomenon often signals the last gasp of an aging bull market. It occurs when the market leaders falter and become laggards, while the laggards become the new leaders.

Bull runs often are driven by a small number of strong stocks. These are the market leaders. When these leaders stumble, it usually means that the broader indices will follow.

The markets performed a 180-degree pivot halfway through 2017, with the leaders of the first half turning into laggards as the year wore on.

During the first half of 2017, uncertainty drove investors into defensive sectors. Utilities and other high yielders did well. This trend has reversed in recent months. The Federal Reserve’s tightening has prompted rotation into financials, industrials, and consumer discretionary.

The Federal Reserve is unwinding its $4.5 trillion balance sheet. The Fed is on course to hike rates again in December. It plans three more increases in 2018.

A stunning example of sector rotation now is the movement out of technology and into financial services. Tech stocks are overheated. The Nasdaq has been falling, as investors cash out. After a big run-up, tech stocks are taking a breather. The Nasdaq has risen by more than 30% this year. Prudent investors are pocketing gains from the “FANG” stocks. These red-hot darlings are cooling off.

The Nasdaq started Tuesday deeply in the red but pared losses by the closing bell. Investors are piling into stocks that appear to be the biggest winners from tax overhaul. Banks top the list. Cuts in corporate tax rates will lift banks, because they take advantage of few deductions.

Banks also are benefiting from strong earnings, higher interest rates, and economic recovery. Rising energy prices help. Many banks are stuck with sour energy loans. As oil and gas price rise, it’s easier for energy firms to pay back loans.

Banks should benefit from a higher rate spread. Consumers will see a boost if the dollar stays strong. When the “wealth effect” grows, banks enjoy bigger loan portfolios. Holiday shopping is robust. Consumers are taking on more debt, which fills bank coffers.

Cash registers are chiming this holiday season. The solid labor market and actual wage growth are brightening moods. Consumers are wielding their credit cards with confidence.

Wall Street expects strong earnings growth in the fourth quarter. The consensus pegs the earnings growth rate for the S&P 500 in the fourth quarter at 10.5%. All 11 sectors are on track to report earnings growth for the quarter. Analysts expect the financial sector to generate powerful earnings growth in the quarter of 12.5%.

The Trump administration’s reduction of regulations also pleases bankers. Making money is easier when there’s less oversight. There’s an old saying on Wall Street: Don’t fight the trend. The trend belongs to financial services.

But risks lie ahead. The S&P 500’s forward 12-month price-to-earnings (P/E) ratio is 18.3. This P/E ratio is above the five-year average of 15.8 and above the 10-year average of 14.1. The economic cycle is due for a shift. Recoveries last about eight years; the current expansion is about nine years old.

During the last recession, no sector was hit harder than financials. Banks took the worst beating of all.

You may be tempted to pile into financial services through an index fund. But in today’s dicey conditions, stock picking matters. There are good values out there if you know where to look. The strategists at Investing Daily can help you with this task.

Tuesday Market Wrap

  • DJIA: -0.45% or -109.41 points to close at 24,180.64
  • S&P 500: -0.37% or -9.87 points to close at 2,629.57
  • Nasdaq: -0.19% or -13.15 points to close at 6,762.21

Tuesday’s Big Gainers

  • Barnes & Noble Education (NYSE: BNED) +23.21%

Earnings beat expectations.

  • Snap (NYSE: SNAP) +10.10%

Social media firm simplifies app design.

  • Regal Entertainment Group (NYSE: RGC) +9.50%

Movie theater chain eyes sale to rival.

Tuesday’s Big Losers

  • Edison International (NYSE: EIX) -12.78%

California fire triggers power outage for utility’s customers.

  • Cleveland Cliffs (NYSE: CLF) -10.44%

Investors give thumbs down to miner’s note offerings.

  • Toll Brothers (NYSE: TOL) -7.19%

Tax overhaul could hurt luxury home builder.

Letters to the Editor

“I’ve been reading a lot of pessimistic analysis lately. How worried should I be about a crash?” — Tony L.

The bears are growling again: Sell stocks, sell the kids, sell everything! At Investing Daily, we’re cautious. But we’re not doomsters. We expect a correction of 5%-10%, not a crash that’s worse.

Turn to “defensive growth.” Avoid overpriced equities. But don’t abandon the market altogether. This aging bull may have longer to run. That’s especially true, now that the GOP has pushed through tax cuts.

What are your biggest investment fears? Share them with us; we can help. Drop me a line:

John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.


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