Why Tax Reform May Not Be As Great As The Market Hopes

Posted On February 22, 2017 10:17 pm

The stock market has been on an absolute tear recently (Dow has risen 9 straight days, the longest winning streak in 30 years), mainly due to market optimism about the effects of tax reform on corporate earnings going forward. BUT it’s important for investors to keep a few things in mind.

First, tax reform, as opposed to changes in existing tax rates, is VERY complicated. Currently the proposals by Paul Ryan (House Speaker) and many in the GOP calls for:

  1. Reduction in corporate tax rate from 35% to 20%
  2. 10% repatriation holiday
  3. 20% Border Adjustement Tax
  4. Allowance for instand depreciation of capital spending against earnings
  5. Elimination of debt interest deductability

Changing the tax code in such a way is likely to take a lot longer than many people realize. For example, why Mr. Ryan has said that the GOP hopes to pass these changes by July, the Bush era tax cuts, (no reform just changes in existing tax rates) took 18 months to pass. In the meanwhile such reform will need to get past the deficit hawks who have spent years crying out against massive deficits and a national debt that is now at $20 trillion.

And given that Treasury’s last fiscal quarter (ending Jan of 2017) saw record revenue of $1.085 trillion but also record spending of $1.242 trillion. In other words, despite an improving economy resulting in plenty of revenue, the deficit still came in at an annual rate of $628 billion. This is a big reason why Mr. Ryan has said that tax reform will be revenue neutral, meaning that any cuts will be balanced by tax increased elsewhere, as well as faster economic growth.

This also, along with Trump’s penchent for instituting high tarrifs that could trigger a trade war and recession, explains why the propsed reforms include a border adjust tax or BAT. The BAT is designed to tax imports and use the funds to provide a credit to exporters, thus making US exports more competive. However, there are a few big problems with this idea.

First, it will immediately cause a spike in inflation that is already at a four year high. In fact, the Fed’s latest meeting showed that a rate hike now may be coming as early as March, due to concerns of acceleraring prices. Rising US interest rates means higher yields on US investments, which naturally attracts foreign capital, increases the demand for US Dollars, and leads to a rising dollar.

The problem is that the dollar is up 26% in the last 2 years, which is creating major growth headwinds for transnational corporations such as Coca-Cola, 3M, and Johnson & Johnson. If a BAT causes inflation to rise even faster than the dollar could strengthen even further. However, when combined with a BAT the US dollar could be set to soar as much as 25% to 30% in the next few years. That’s because the 20% credit that exporters would gain as a result of the tax would increase demand for US exports, which means further strengthening of the dollar.

All of which means that, despite the lowering of corporate rates, certain multi-national blue chip could see major growth headwinds in their top and bottom lines.

Then there is the potential elimination of interest deductability which could hit certain capital intensive industries very hard, especially regulated utilities. That’s because these companies have spent decades borrowing in order to build out massive infrastructure, and have counted on deducting the interest on their debt to help boost EPS, (and dividend growth). However, now this deductability is threatened and that could be bad news for some of my favorite utility stocks, including Dominion Resources, and NextEra Energy, which would see their EPS decline by 8.5%, and 11% respectively if this comes to pass.

So does that mean that tax reform is a total bust? Is the market’s rally insane and it’s now time to sell everything before Wall Street realizes the madness of current valuations? The answer is “no”. We still haven’t seen the final proposal of the administration’s tax reforms (coming in the next 1-2 weeks). Furthermore we will still likely need to wait a year or more to see what the GOP Congress can actually get passed.

In the meantime the massive boost in economic optimism, as well as better than expected economic growth is still set to boost corporate earnings in 2017 and beyond. In addition, only 52% of Americans are even in the market, due to terrible memories of the Great Recession. This means that there is still a vast potential source of capital, (besides the $2.5 trillion in offshore cash that is waiting to get repatriated) that could continue to drive prices higher.

Rather, just remember that, even at record highs, something is always on sale on Wall Street. There is always an out of favor industry, and thus quality dividend growth names worth owning, trading at 10%, 15%, or 20+% under fair value. In fact, here are my favorite 45 dividend growth names to own right now, taken from either our own DVDGI index, my real money portfolio or my list of alternates (in case one of my companies cuts its dividend or gets acquired).

Undervalued Dividend Growth Stocks Worth Owning

Hanesbrands (HBI): 37% undervalued
HollyFrontier (HFC): 34%
Williams-Sonoma (WSM): 34%
Tesoro Corp (TSO): 29%
McKessen (MCK): 25%
VF Corp (VFC): 24%
Albemarle (ALB): 23%
CVS Health (CVS): 23%
Expedia (EXPE): 22%
Teva Pharmaceuticals (TEVA): 20%
L Brands (LB): 19%
Lazard (LAZ): 19%
Ingredion (INGR): 19%
Gilead Sciences (GILD): 18%
Shire PLC (SHPG): 18%
Walt Disney (DIS): 18%
Marathon Petroleum (MPC): 17%
Polaris Industries (PII): 16%
Royal Dutch Shell (RDS.A): 16%
Kimco Realty (KIM): 16%
Qualcomm (QCOM): 16%
AbbVie (ABBV): 16%
Perrigo (PRGO): 16%
Compass Minerals International (CMP): 15%
Tractor Supply (TSCO): 15%
Gildan Activewear (GIL): 15%
Ford (F): 14%
Taubman Centers (TCO): 14%
International Flavors & Fragrences (IFF): 14%
General Motors (GM): 14%
Macerich Co (MAC): 14%
Anheuser-Bush InBev (BUD): 13%
Simon Property Group (SPG): 13%
Visa (V): 13%
Starbucks (SBUX): 13%
Novartis (NVS): 12%
Sunoco Logistics Partners (SXL): 12%
BT Group (BT): 11%
Amgen (AMGN): 11%
Welltower (HCN): 11%
Novo Nordisk (NVO): 10%
Spectra Energy Partners (SEP): 10%
AmerisourceBergen (ABC): 10%
PulteGroup (PHM): 10%

About author

Dividend Sensei
Dividend Sensei

I'm an Army veteran and former energy dividend writer for The Motley Fool. I currently write for both Seeking Alpha, Simply Safe Dividends, and DividendSensei.com My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams, and enrich their lives. With 22 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams. I'm currently on an epic quest to build a broadly diversified, high-quality, high-yield dividend growth portfolio that: 1. Pays a 5% yield 2. Offers 7% annual dividend growth 3. Pays dividends AT LEAST on a weekly, but preferably, daily basis

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