We hope that you all had a wonderful Thanksgiving! Haven Wealth Group wanted to take a few moments to share some common themes that we have been receiving from clients. As always, if we can answer your questions it would be our pleasure.

First we want to touch on recent market action. We have been invested in a number of Technology stocks on the NASDAQ and yesterday we saw a massive rotation out of technology stocks and into stocks that have higher effective tax rates. We still believe in these Tech stocks and will continue to monitor them closely, but we also plan to participate in the ongoing sector rotation. We will touch on the sectors we believe will be beneficiaries of tax cuts below.

On to the questions:

Question 1 – With the market in record territory, are we in a bubble?  

We believe equity valuations are above average, but not at extreme levels. The average P/E (Price to Earnings ratio) over the past 92 years has been 17.2 times earnings (Please see the attached chart on long term equity valuations).  To put recent valuations into context, at the market peak in 2000, the P/E of the S&P 500 was over 40x’s earnings.  At the 2007 market top, the P/E ratio was over 124x’s earnings.  Today the P/E is 23 times 2017 estimated earnings. While this is above average, it is our thought that we are not near (bubble) extreme levels.

Question 2 – Are tax cuts already priced into the market? 

The primary reason the market has rallied is due to anticipation of corporate tax cuts, which are not priced into the market.  The reason these are not priced into the market is because corporations provide earnings guidance each quarter to investors.  No companies have projected lower tax rates into their earnings guidance. Tax cuts are generally expansionary to the economy. The big question for long term success is whether the tax cuts will improve GDP growth rates to the +3% range.  It is believed that this rate of GDP growth will be required to provide enough economic growth to accomplish tax cuts without expanding the deficit.  No matter the long term effect we believe that tax cuts will be beneficial to the market for the next 6+ months.

Question 3 – What sectors and stocks will benefit the most from lower corporate Tax Rates?

Sectors that may benefit more from lower taxes include Financials, Telecom, Industrials, and Energy.  These sectors have been paying considerably higher tax rates than sectors that have earnings parked overseas.  The best performing sectors yesterday were Telecom and Financials.  Many of the bank stocks are at appropriate buy points.  Below is a quick idea list of stocks that we believe will be beneficiaries of lower tax rates.

Financials:

JPM, BBT, ZION, BAC, CMA, FITB, ETFC, SCHW

Consumer Discretionary:  If Individual tax cuts accompany corporate tax cuts, this sector may benefit from higher consumer spending.

AZO, ORLY, DLTR, ROST

Health Care:

UNH

 

Question 4 – What can we expect from the markets going forward?

It appears that tax cuts may actually materialize. If corporate tax cuts do happen, company profits will rise as a direct result of these tax cuts. Here is the math:

The current corporate tax rate is 35%.  If it is lowered to 25% or even 20%, companies will have the differential to spend.  Companies could increase their dividends to investors, buy back their stock, or expand their businesses.  All of these scenarios are very, very positive for stocks.  Below is the expected earnings of the S&P 500 based on a 35%, 25%, and 20% tax rate.  This is a “general” analysis to see what potential earnings and valuations are based on lower corporate tax rates.

Actual 2016 Estimated 2017 Estimated 2018
Price of S&P 500 as of 11/29/2017              2,627              2,627              2,627
S&P500 Earnings 94.55 114.92 132.86
Assumes a 35% Tax Rate
Valuation – Price / Earnings 27.8X 22.9X 19.8X
Expected S&P500 Earnings Increase to: 153.3
Assuming a 25% Tax Rate
Valuation – Price / Earnings Ratio drops to: 17.1X
Expected S&P 500 Earnings Increase to: 163.52
Assuming a 20% Tax Rate
Valuation – Price / Earnings Ratio drops to: 16.1X

 

Of note, the earnings are estimates, and subject to change.  Also, individual companies pay taxes at different rates.  This is merely an illustration to explain why the markets are rising. Also, the market typically looks forward 9-12 months when determining equity prices. Since 2017 is almost over, the important numbers to watch are estimated earnings for 2018 and 2019.

We always enjoy your comments and insights, so please don’t be a stranger.

Warmest Regards,

Richea, Charlie and the Haven Wealth Team


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