Locally based CPA firm since 1956

There are many roadblocks keeping stocks from shifting gears. The U.S. stock market has traded sideways since its all-time high, May 21, 2015. While the market indices are within a hairs breath of the record close, there are still headwinds that make it hard for the market to break out. For the month of May the market finished on a mixed day with the DOW up about 0.25% for the month and about 2% year-to-date. The S&P was up about 1.33% for the month and about 2.7% year-to-date.

One challenge keeping stocks from climbing is cost. Stocks aren’t cheap. The good news is the large-company S&P 500 has rallied since the low of February 11. The bad news is the Price to Earnings (PE) ratio for the next 4 estimated quarters is about 17 times earnings, placing it about 15% higher than the average PE of 14.7 over the past 50 years. Unless we get some meaningful earnings growth, the S&P will have a hard time breaking out to the upside, and it wouldn’t take much bad news to create another correction like February.

Second, when indices bounce against their all-time highs, Wall Street calls this a “glass-ceiling” or “overhead resistance.” In short, it means that it is often tough for an index to hit new highs on its first few tries after a serious slump like we suffered in February. Prices tend to bounce up off the lows only to bounce down off the previous ceiling creating a trading range. Generally, headline news is the catalyst necessary to break out of the range either to the upside, or the downside. Anyone care to guess what the next “big” headline will be?

Third, the dollar’s strength creates a headwind for U.S. Multinationals as it makes their products more expensive. Fourth, political risk is back. Election angst is on the rise. Wall Street hates uncertainty and the 2016 presidential campaign, if anything, is unpredictable.

Over past election years, the market typically does not do well in the final year of a President’s second term. This trend is likely attributable to uncertainty. The market is concerned about changing Federal policy, new regulations, changes in Foreign Policy, and questions around new leadership focus. It seems that it makes little difference whether or not Republicans or Democrats win the election. Generally, after the election, when the uncertainty surrounding who will lead subsides, the markets tend to rally.

Last, but certainly not least, profits matter. Corporate earnings have been shrinking for three consecutive quarters, and Wall Street will need to see proof that economic growth is moving back toward 2% – 2 ½ % and the earnings recession has run its course. With the first quarter GDP number coming in somewhere between 0.5% and 1%, and the second quarter leading indicators not indicating any pick up in either Global or U.S. economic activity, the S&P 500 will have a hard time holding to that 17 multiple mentioned above.

The U.S. Economy

“Our Choking Economy” is the headline on the front page in the May 23 issue of Time magazine. The author goes on to quote some startling results of a recent poll; only 19% of Americans ages 18-29 identify themselves as capitalists. In the richest, most market-oriented, most successful country in the history of the world, only 19% of our young folks entering the workforce are capitalist, and of that same group, only 42% said they support capitalism. This is a clear lack of faith in a system that, over 200 hundred years, turned a nation of farmers into the most prosperous nation in human history. I believe this severe expression of lack of support is also reflected in our 2016 presidential campaigns.

I contend that this crisis of faith goes far beyond rich bankers, too-big to fail financial institutions, offshore tax avoidance and other momentary outrage. So what’s the solution? We must fix our system.

Our current system is one that incentivizes bad behavior. We have a welfare system that pays more to folks who have children and who are not married than it does to those who have children and are married. The incentive, if you have children, is do-so out of wedlock. This promotes the destruction of the family unit that most social workers point to as the primary reason for poverty and poor education.

Another flaw in our current system is that we have a tax code that incentivizes debt over investment. Take my situation for example; I deduct the interest on my home loan but I must pay 20% or more on gains from investments. How about we take away the deduction on home loans and simultaneously add a third tier to capital gains tax? I am thinking of one that gives a bigger tax break for investments held longer than 3 years rather than those held only one year?

Apple best exemplifies another example of our broken tax code that incentivizes bad behavior. Maker of the iPhone, iPad, and iWatch, Apple pays less by issuing a new bond at 4% than they would if they repatriate their estimated 181 billion dollars and invest it somewhere in the U.S. A similar disincentive has caused several large companies such as Medtronic and Ford to invest more outside the U.S. and/or take advantage of a tax inversion rather than invest at home, in the U.S.

Our system further is built to favor consumer spending over saving. Just look at the U.S. measure of GDP, over 70% is measured in some fashion by consumer spending. Why? Because our system promotes and rewards spending, over investing, or saving.

What’s the solution? First there must be political will. There must be a willingness to evaluate the system and find out why it doesn’t work, why it was designed that way and why it remains that way. Then formulate a plan rich with incentives for behavior that benefits the U.S. rather than incentives that discourage long-term investment and good behavior. Finally, we need the scarcest ingredient of all, the courage to change it.

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