The Case for the Bulls

Yesterday I promised to share the case for a continued bull market.

Arguing for a continuing rise in stock prices, Donald Luskin, chief investment officer at Trend Macrolytics LLC, wrote in The Wall Street Journal that, “Tax Reform Has Released the Bulls.”

Luskin wrote that, “By traditional measures of value, stocks do seem expensive right now. But those metrics have flaws, the worst of which is a tendency to look at the past rather than the future. Markets, by their nature, do the opposite.”

The typical P/E ratio shows stock prices as a multiple of each company’s earnings for the past year. What’s important, though, he wrote, “isn’t last year’s earnings, it’s next year’s—and all the years to come.”

He calls Shiller’s CAPE ratio “a misguided attempt not to be fooled by short-term fluctuations,” because the CAPE ratio is based on average earnings over the previous decade. Using earnings from 2007 through 2017, stock prices appear to be valued as they were in 1929, just before the market crashed.

“But that’s only because the past decade of earnings includes the catastrophe of 2008-09,” Luskin wrote. “This makes earnings look artificially low, even though it has little relevance for today.”

Using earnings estimates for the year ahead when calculating the P/E ratio, prices are a bit above average, but “nothing scary.” Prices are well below the level they were at during the tech bubble that began in 1999 and are consistent with prices from the 1950s through the 1970s.

However, because of tax reform, a higher P/E could become prevalent. When the corporate tax rate was 35%, after-tax earnings were just 65 cents on the dollar. With the cut to 21%, after-tax earnings jump to 79 cents on the dollar.

“That’s earnings growth of 21.5% with the stroke of Mr. Trump’s pen,” Luskin wrote.

The lower cost of doing business should also result in an increase in startup businesses. We’ve written that in recent years, the number of business failures in the U.S. has exceeded the number of startups for the first time in the country’s history. Hopefully, we can now reverse that trend.

In addition, lower taxes are likely to drive some American companies with operations abroad to bring that business back to the U.S.—and it will also keep many companies from transferring operations to other countries. Foreign companies, likewise, will be more likely to be attracted to the U.S.

“All of this again will create new businesses, factories, jobs and earnings,” according to Luskin.

To retain their competitiveness, other countries will likely react by reducing their tax rates, which would be “the delightful opposite of protectionism,” as countries compete to “liberate their productive sector from the deadweight costs of corporate taxation.”

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