This week's key themes presented by Goldman's David Kostin: "The weak fiscal condition of federal, state and local governments, and corporate tax reform dominated our discussions this week with hedge fund and mutual fund portfolio managers. So far, 207 firms in the S&P 500 have reported 4Q results (55% of total cap). 45% of companies reporting have beat consensus earnings estimates by more than one standard deviation (above the historical average of 41%) and 9% have missed estimates (vs. average of 14%). The average EPS surprise has been nearly 10%, above the 4% historical average. Excluding Financials, there are fewer positive surprises (44%) and fewer negative surprises (6%)." For now Kostin is still sticking to his 1,500 forecast: "The S&P 500 rose 1.5% this week. Industrials was the best-performing sector (+3.0%) while Consumer Staples was the worst-performing sector (-0.5%). We expect the S&P 500 to rise to 1500 in 12 months (+15%)." We give this forecast three months max. After all, the path for QE3 must be paved with good intentions. And the kicker: "We expect a combination of 8% sales growth and 30 bp of net margin expansion to 8.8% will combine to boost EPS by 14% to $96 per share." Ongoing margin expansion as most companies are prewarning about maring collapses... This is beyond painful.
Corporate taxes, the weak fiscal condition of federal, state and local governments, and 4Q 2010 earnings results dominated our discussions this week with hedge fund and mutual fund portfolio managers.
A report from the Congressional Budget Office (CBO) showing the US federal deficit would be $1.48 trillion in FY 2011, more than $400 billion greater than estimated 12 months ago, prompted a new round of questions from investors about the appropriate yield and risk premium that should be assigned to US bonds and stocks. The decision by Standard & Poor’s to lower the sovereign credit rating of Japan to AA- focused equity investor attention on the tail risk possibility of a credit downgrade of the US. Last week during our 19th annual strategy conferences across Europe, investors raised the same concerns about the unsustainably weak fiscal position of the US and prospects for higher Treasury yields and lower stock prices.
The US is certainly not alone in its budgetary imbalances and sovereign debt issuance requirements. We have noted previously that with $14.0 trillion of debt currently outstanding the US is on track to hit the existing federal debt ceiling of $14.3 trillion by March or April 2011. Under rules adopted by the House of Representatives under Speaker Boehner, separate votes must take place to raise the debt ceiling and to pass the actual budget.
With many Republican representatives coming to Washington, DC on the Tea Party austerity platform, the media attention surrounding raising the ceiling will be significant. We expect the debt ceiling ultimately will be raised.
Investment implications: (1) we do not view a spike in US interest rates and falling equity prices as the most probable path for financial markets. Many recent US economic indicators have exhibited strength including consumer confidence, new home sales, durable goods orders, and GDP. However, a dip in the home price index and mortgage applications suggest intermediate term weakness. Goldman Sachs Economics forecasts 10-year US Treasury yields will rise by roughly 50 bp to 3.75% at year-end 2011 and another 50 bp next year to reach 4.25% at year-end 2012.
(2) We forecast S&P 500 will rise roughly 17% to reach 1500 at year-end 2011. We expect a combination of 8% sales growth and 30 bp of net margin expansion to 8.8% will combine to boost EPS by 14% to $96 per share.
(3) Volatility is likely to spike as debt outstanding approaches the ceiling, repeating a pattern from 1995 when the government last experienced a temporary shut-down of non-essential government services when a budget compromise could not be reached.
President Obama’s “State of the Union” speech mentioned eliminating tax loopholes and using the savings to lower the US corporate tax rate. Unfortunately, no specific proposal was made and details matter when the tax code is concerned.
The current statutory marginal US corporate tax rate equals 35%. Including state taxes lifts the total marginal tax rate to 39%. President Obama argued that cutting the federal corporate tax rate would position the US closer to many other countries and make domestic firms more competitive with overseas counterparts, spurring new orders, capital spending, new hiring and leading to faster domestic economic growth. Exhibit 1 highlights that the US statutory corporate income tax rate (federal and state) ranks well above most other countries.
The argument that the US needs to reduce its existing corporate tax rate to more closely align itself with other nations seems similar to the mercantilist tendencies exhibited last year as countries essentially competed to devalue their currencies in a bid to boost competitiveness of their export industries. In the case of taxes, each country (or state) wants to make the business environment more hospitable than its neighbors to spur job creation.
However, very few firms actually pay taxes at the statutory rate. For example, the median effective tax rate for the firms in the S&P 500 equals 32% (see Exhibit 3). The map in Exhibit 4 indicates each state’s combined federal and state corporate tax rate. States with adjusted tax rates of 35% have no corporate income taxes.
From an investor perspective it remains unclear whether lowering the statutory US tax rate and closing certain tax loopholes will actually have an impact on profits, and hence valuation of the market. In fact, changing the tax code may not even result in any additional revenue to the federal government given effective rates are so far below the statutory rate.
The top 10 and bottom 10 stocks in the S&P 500, ranked by the trailing five year average effective tax rates, appear in Exhibit 2. For example, Chevron (CVX) and Exxon Mobil (XOM) paid taxes at an average rate of 43% and 42%, respectively, over the past five years. Meanwhile, Altera (ALTR) and Waters (WAT) paid taxes at an average rate of just 13% and 15%, respectively. As noted above, future effective tax rates will be critically dependant on the specifics of any legislation.
Below is the tax-related chart showing how Obama continues to be full of hot air:
And the one chart that confirms that in the hot air department, Goldman is close behind: S&P margins...
Presenting the sell-side groupthink: 1 Month earnings revision sentiment by sector. Go long consumer staples and avoid industrials like the plague.
Aggregate S&P metrics: the one key one - FCF yield at 6%.
Time for a drubbing in the Russell 200: and yes, the RUT is now down 1% for the year.
And as a reminder, a week ago we pointed out the Russell 2000 stocks with the highest beta. Those who believe the market is due for some normalcy, should go balls to walls short these names (as a basket).
Full Kostin presentation: