By Gene D. Balas
We donít yet know what, if any, forthcoming tax proposals will become law. However, one potential idea that might be included in such a plan could be to encourage businesses to invest more in their property, plant, equipment, and technologies. After all, in the long run, that would likely help the economy, as it may boost productivity – an essential ingredient in the potential growth rate of the economy. And in the short term, the very investment itself is a direct addition to GDP.
[su_pullquote align=’right’]It really isnít so simple to magically make money appear by legislation.[/su_pullquote]
But, as with many things in life, it really isnít so simple to magically make money appear by legislation. There are complicated side effects and interactions. So, letís take a walk through the data and connect some of the dots along the way to see how (or if) this could actually negatively impact consumer spending.
Funds for investing in capital expenditures (capex) will have to come from somewhere else. Corporations canít simply print money, so the likely source of those funds may be from monies companies had been using to buy back shares.
Share buybacks help the stock market for two reasons. First is the obvious demand for those shares in the stock market. Companies in the S&P 500 have spent more than $2.5 trillion on share buybacks in the five years through 2016ís third quarter, according to FactSet. But the second reason buybacks help the market, though, is just as important: By reducing the number of shares outstanding, then, presto, earnings per share is then higher. In fact, the 5.3% in annualized, cyclically-adjusted earnings per share growth since 2009 would be less than half as much if not for the effect of buybacks, according to data from FactSet.
[su_pullquote]Sales, unlike earnings, are not distorted by accounting policies.[/su_pullquote]
While we canít predict actual market outcomes, some may argue the market could be considered pricey, as measured by the ratio of the S&P 500 to sales. Sales, unlike earnings, are not distorted by accounting policies (or indeed, the number of shares outstanding). That provides a cleaner look at the valuations of the market over time. As seen in the nearby graph, the market may arguably be rather expensive.The market may arguably be rather expensive | Photo Courtesy: NDR
If companies invest funds in things that benefit the economy, they may correspondingly invest less in things that benefit the stock market, like their own shares. The stock market is like any other market: Prices are set by supply and demand. If there is less demand for shares coming from the issuer of said shares, the market may not go up.
Without an ever-rising (or possibly even declining) market, then theoretically, at least, investors might feel a need to save more for retirement or other goals out of their paychecks instead of relying on the courtesy of corporations to buy their stock from them. If this is true, then that could be a drag on consumer spending.
The economy and markets are complex organisms
So, this much might make intuitive sense. But it comes with a huge caveat: There are many other factors besides the stock market that can influence consumer spending and saving. Indeed, there have been times when consumer spending has fallen along with the value of the market – just as consumer spending had also risen after sharp drops in the market. The October 1987 stock market crash did nothing to stop the 1980s economic expansion. Itís hard to pin down the relationship of one variable to just one other variable.
Our main point, though, is not to make a forecast of the direction of the market or the levels of consumer spending or saving.
Instead, this discussion is intended to illustrate just how complex the economy is. It rarely responds to just one factor, like tax incentives or the level of the stock market. In our example above, weíve walked through unintended side effects of just one pathway. Multiply this by hundreds of other variables, and you can see where it is far from a slam-dunk case that one lever – tax policy – can influence markedly the economy or the market as a whole.
Indeed, former president Ronald Reagan cut taxes, and the market went up and the economy expanded in the 1980s. Former president Bill Clinton raised taxes, and the market again rose while the economy grew in the 1990s.
The bottom line is that investors would be wise to consider many more factors when investing than a single variable. Often, staying the course instead of responding to either fear or euphoria might be a better course of action. Recognizing the tendency of investors to respond to just one variable and the historical examples of why this hasnít yielded results is proof of the economyís complicated nature. Avoid the temptation to have selective attention.
Gene Balas, CFA, is a Portfolio Manager at United Capital Financial Advisers, LLC. He previously was a columnist for The Street’s Real Money site, covering economics, in addition to his role as Chief Investment Strategist at an RIA.
This article was originally published on Econintersect.
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