The Trump tax trade appears to be rallying the wrong stocks.
The Dow Jones Industrial Average jumped 255 points on Tuesday, and another 65 points by midday Wednesday, after the Senate Budget Committee passed the tax bill. But while investors seem to be cheering the Republican plan to cut the government levy on corporations and wealthy Americans, the stocks of high-tax companies that would benefit the most have oddly risen the least.
Shares of the companies with the highest tax rates, which did take off after the election, have lagged lately, returning just 13 percent this year compared with nearly 20 percent for market in general as measured by the S&P 500. Even odder, the shares of the 100 companies in the S&P 500 that had the lowest tax rates last year are some of the market's best performers, up 25 percent on average this year, or nearly double the 100 highest-paying ones.
What's going on? Let me propose three possible answers. First, investors still don't believe a tax cut is going to happen, and they do seem to have had their doubts along the way. But, as I have said in the past, the stock market's nearly 20 percent climb this year can't be explained by better earnings alone. The anticipation of tax cuts, at least to me, seems clearly part of what has propelled the S&P 500 this year. But it's possible that something else has been driving the Dow higher, like repeal of regulations, or the growing assumption that interest rates won't rise that much. Also on Tuesday, Jerome Powell, Trump's nominee to chair the Federal Reserve, who many believe will continue Janet Yellen's low-rate policies, did well in his Senate confirmation hearing.
The second answer is that investors have been buying the wrong stocks and that high-tax stocks are a screaming buy. That seems unlikely, but there does appear to be some evidence for that. The market's highest tax payers are trading at a discount to the lowest ones. The average price-to-earnings ratio of the high tax paying group is just over 19, based on the past 12 months of earnings. The lowest tax paying ones have a P/E of over 24.
The problem with that answer, though, is where the high tax payers get their profits. High tax payers generally earn more of their money in the U.S., which taxes domestic profits at one of the highest rates in the world. But much of the surprising growth this year, and likely next, is coming from overseas. Most forecasters believe that the U.S. economy will plod along at about a 2 percent growth rate, even after the tax bill. What's more, technology stocks are often among the lowest tax payers, 24 in the low paying group, compared with just seven among the high tax payers. Combine more tech with more profits coming from overseas and it is likely that the lower paying group will have still have higher profits next year, even factoring in the tax cut.
Lastly, the share prices of the low tax payers are going to get their own boost from the tax bill. Beside cutting their tax rate, there's another huge benefit for corporations in the proposed tax bill: repatriation. Companies will have to pay an 8 percent tax on their past overseas earnings. That will cause an earnings hit in 2018. But it will also allow them to bring back home trillions of dollars in cash stashed overseas, which in the past would have been subject to the normal 35 percent tax. And a number of strategists assume that much of that cash will be used to buy back stock or pay dividends, which should boost stock prices. Still, over the longer term, low tax payers will benefit the least from the tax bill.
That leads me to the third, and I think most likely, answer: Investors have factored in the tax cut and said, "Meh." Basically, the market is saying the tax bill won't produce the huge job-creation, wage-boosting benefit that President Trump and Republicans are promising. Instead, investors have decided that you will do better off owning stocks of companies with the most growth potential and not the ones most likely to get an artificial boost from the government. That's what investors appear to be betting, and that's usually a pretty good one.