The VIX is falling and stocks are priced for perfection. But, before we get started, I encourage everyone to pause this weekend and remember those who came before us. Their quest for independence lives today and we should never forget that freedom in a free country is anything but free. Thank you to all who made America great and to those who continue fighting for our independence and freedom.
Advancing through 2021, U.S. tax rates are likely headed higher along with predictable inflation. Add a large dose of regulatory risks and shifting growth momentum, suddenly we are less enthusiastic about U.S. equities in the near term, with the VIX falling and stocks priced for perfection, focus is key. Don’t mistake our waning enthusiasm for giving up on the economy. Instead, our position is more akin to how quickly the labor market is healing amid the economic restart. Actually, equities in developed markets outside the U.S. seem better positioned to capture economic restart upside.
Amid the restart and what appears a burgeoning economy, potentially higher taxes and more regulations pose challenges to record-setting performances of U.S. stocks. Every investor wants to know “if stocks are going to correct”? The simple answer is, stocks eventually revert to the mean (aka, a market correction). The question that is impossible to answer, and perhaps more important is, “when will stocks correct”? Looking back, stocks have been resilient, despite a global pandemic, presidential election, myriad executive orders, and looming changes to our tax code. Our view is the eventual tax increases will likely be less than proposed by the administration.
Regardless of adjustments to proposed tax legislation, the spending coming out of Washington is enormous, unlike anything the world has seen. At this point, President Biden and company has signed a bipartisan infrastructure plan, much smaller than its original $4 trillion proposal. Of course, funding for this massive debt requires more tax; corporations and high-income individuals (those making more than $400,000 per year) are in the crosshair. Lest we forget, nothing is free and only one thing provides funding for our government, taxes. Now, if you credulously believe higher taxes won’t affect you, think again. In fact, we believe everyone will feel the effects of higher taxes; directly (based on earned income and capital gains, or indirectly, based on increasing cost of goods as a result of higher corporate tax). The U.S. has also endorsed a global minimum tax scheme, against the backdrop of an OECD initiative to tax cross-border digital services and limit multinationals from shifting profit to lower-tax jurisdictions. It is estimated that approximately $100 billion of tax revenue generated would be distributed to jurisdictions around the world.
Many things to consider and uncertainties abound on the administration’s tax plan, hurdles in Congress should be expected. We speculate the final version will be well below the proposed price tag with fewer offsetting tax hikes. Of course, our optimism is not without risks. Relating to the stock market, if the proposed 28% corporate income tax rate and a 21% global minimum tax were imposed, earnings per share of the S&P 500 Index would be (by our estimates) 7% lower in 2022. What does this mean in the present?
Looking to the Volatility Index (VIX), it averaged in the mid-teens for five years in a row before spiking to an average of 29 in 2020 as entered a global pandemic. Averages are a great way to discern trends, but they tend to cloak shorter-term readings. For example, the VIX soared to 85 in March 2020 as the U.S. economy came to a sudden stop. One year later, having endured many speed bumps along the way such as a recession, second and third COVID-19 waves, an extraordinarily divisive U.S. presidential election, and fears of inflation, the VIX has slowly (but surely) moved back into those mid-teen readings. Even more impressive, the VIX is resting below 16 for the first time since February 2020. Nevertheless, investors should remain alert and aware that on a relative basis, stocks don’t appear severely overpriced.
Red Hot Housing Market Late in the month, the National Association of Realtors announced that existing-home sales decreased for a fourth straight month in May. Further, only one major U.S. region recorded a month-over-month increase, while the other three regions saw sales decline. However, each of the four areas again registered double-digit year-over-year gains, which is not surprising given the state of the real estate market and the economy, in general, this time last year. According to the release from the NAR, total existing-home sales – completed transactions that include single-family homes, townhomes, condominiums, and co-ops – dropped 0.9% from April to an annual rate of 5.80 million in May. But sales in total were up a stunning 44.6% from just one year ago (May 2020). It’s hard to say if this prodigious frenzy on real estate will continue, but low rates and increasing consumer confidence point to more of the same.
The bottom line: Since 1920, the S&P 500 has recorded a 5% pullback three times a year on average and a 10% correction once every year and a half. We are optimistic and look for stocks to outpace bonds. However, the volatility index (VIX) is falling and stocks are priced for perfection. In this environment, we impugn their ability to remain at current levels. It is in this kind of environment that investors and money managers must remain vigilant in their quest to find high-quality companies, with increasing dividends, strong balance sheets, and experienced management teams.
Uncertainties around potential tax increases are making it hard for investors to position for the potential impact. For example, what value can be found in U.S. Treasuries? Domestic equities are also coming under pressure from potentially higher taxes and other factors. That leads us to small and medium-cap U.S. companies. Given the tax increases and regulations targeting large multinational companies, smaller companies may become more attractive with the potential for greater upside. Other strategic opportunities are tax-efficient strategies that allow taxable investors to better control the timing of their capital gains and distributions. Federal Reserve Chair Jerome Powell said the Fed would not rush to raise interest rates on inflation fears alone after Fed officials embraced higher 2021 inflation as contributing to their policy objectives and opened the door to a 2023 lift-off of policy rates.
Summer is upon us, which typically is a period of subpar stock returns. The S&P 500 has banked a low double-digit total return heading into the heat of summer. It is plausible that stocks sustain some melting of excessive gains but we mostly see such an event as a healthy pullback. Even with Fed speak rattling the markets, we believe stocks are poised for a positive second half of 2021; reopening the economy should continue, leading to broad market advances. Now is a great time to consider rebalancing or adjusting your allocation. Talk to us and learn how!
Happy 4th of July,
Phillip L. Clark, RFC