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Friday is a consolidation day, with beaten-up defensive groups like real estate, utilities and consumer staples up fractionally.
The market leaders — banks, industrials and materials — are taking a back seat.
The S&P 500 is poised for its first down week in about a month.
Does that signal the start of a correction? Don't kid yourself. There are almost no bears. The uptrend is very much intact.
But beneath the rally, there has been furious churning. There have been winners and losers.
Investors could have done one simple thing to win without doing anything: stay long the broad market.
Call it Jack Bogle's revenge.
Italians will vote on major referendum Sunday night. There's a lot at stake. Here's why you should care.
This is a referendum on political and economic change. The Italian political system is a mess and one of the main reasons the economy is weak. It's a mess because there is a fatal flaw at the heart of the system. After the disaster of World War II and the Italian experience under the Mussolini dictatorship, the Italian Constitution came into force in 1948.
The objective was to make it very difficult for any one party to control the government. Good in theory, but they went so far in the other direction that nothing can get done.
That's because there are two houses — a lower house (a Chamber of Deputies) and an upper house (a Senate of the Republic). They have the same purpose and are elected at the same time for the same five-year terms. The government must have the support of both houses to survive. All legislation must be passed by both houses. If there are any changes in a bill in one house, it must be approved in the other.
The upshot: because the prime minister is in an inherently weak position, the government is inherently unstable and nothing gets done. And I mean nothing: 61 governments since World War II.
Think about that. Sixty one governments in 70 years.
Here's the good news: Matteo Renzi became prime minister in February 2014 specifically on a platform of change. He pushed through bills that would make the Italian system more responsive and make it easier for a party to govern. He is now submitting those changes to the Italian people in the form of a referendum this Sunday.
The changes would:
1) Greatly weaken the power of the Senate. Italy would effectively become a single-house system, where only the lower house (the Chamber of Deputies) would ratify a government and approve most legislation. The Senate would have much more restricted powers and no right of a veto.
2) Make it easier to govern by reforming the lower house. Any party that wins 40 percent of the votes in either the first or second round of voting will get a "bonus" of 15 percent additional votes, bringing the controlling votes to 55 percent. This will make it much easier to pass legislation. These changes have already been approved but are being challenged in court.
Here's the bad news: Renzi made a mistake by implying he might resign if the electorate did not pass the referendum. The referendum has enemies because many of the existing political parties think — correctly — that they would lose power if the referendum passed. The opposition has launched a campaign to portray Renzi as an autocratic leader, and implied that if the referendum is passed some future Mussolini will seize control of the government with disastrous consequences.
Here's how topsy-turvy the world has become: Renzi was elected as an anti-establishment reformer two years ago, but he is now seen as representing the "establishment."
This turnaround has important implications for the referendum. This is the year of voting against anyone seen to be the establishment. More importantly, it could broadly be deemed "the year of No."
In the U.K. with Brexit. In the U.S. with Trump. In Colombia with the peace agreement with the FARC guerrillas. And now, possibly, with the Italian referendum.
Except that with the Italian referendum, voting "Yes" is a vote against the establishment, voting "No" is a vote in favor of the status quo.
Right now, the poll odds indicate that voters will vote "No" on the referendum.
What happens with a "No" vote? Regardless of whether Renzi resigns, it would certainly make it more difficult for him to govern. His ability to pass any further reforms would certainly be in doubt. More political instability. More caretaker governments. More paralysis. More young people leaving the country because it's impossible to open even an espresso stand due to red tape and absurdly high taxes. More tax evasion. Less growth. Weaker markets.
There's also speculation that the Eurosceptic Five Star Movement would take control of the government in some future election.
Many Italians simply shrug and insist they will muddle through. But the country is slowly fading away.
I'm not joking: no one is having kids because it's too expensive to raise them. The Italian birth rate is below 1.4 babies per household. For most countries, you need roughly 2.1 babies per household to have a stable population.
Italy, like Japan, has a choice: find some way to push the economy into a higher gear or start liberalizing its immigration laws in a big way.
Voting for the status quo is not the way to do that.
Corporate tax cuts: How big an impact on corporate profits?
I've written often that the markets are expensive, and the reason they are expensive is that traders have levitated themselves into believing that earnings are going to expand in 2017 due to a vague combination of tax cuts, infrastructure spending and lower regulations.
It's a powerful combination, but there's not much flesh on the bones. Today Michael Thompson, president and chairman of Standard & Poor's Investment Advisory Services, and his team made a stab at estimating the impact on earnings from corporate tax cuts.
Their conclusion: The impact could be significant. But there's a lot of "ifs."
Why focus on corporate tax cuts? Because it's the only thing in the "Trump rally" that has any kind of plausible numbers associated with it.
President-elect Trump's proposed nominee for U.S. Treasury secretary, Steve Mnunchin, said on our air yesterday that the administration was still targeting a reduction in the corporate tax rate from 35 percent to 15 percent.
The current 2017 estimate for the entire S&P 500 is roughly $131 per share. Thompson estimates that every 1 percentage point reduction in the corporate tax rate could "hypothetically" add $1.31 to 2017 earnings.
So do the math: If there is a full 20 percentage point reduction in the tax rate (from 35 percent to 15 percent), that's $1.31 x 20 = $26.20.
That implies an increase in earnings of close to 20 percent, or $157.
What does that mean for stock prices? The S&P is currently trading at a multiple (PE ratio) of 17, high by historical standards. Applying that 17 multiple to earnings of $157, we get a price on the S&P 500 of roughly 2,669 for 2017.
That is 469 points or roughly 20 percent above where it is today.
That's a lot.
Here's the problem, and why Thompson wisely referred to his calculations as "hypothetical":
1) It's unlikely that all the tax savings will go straight to the bottom line. The money can be used for other purposes. The obvious alternative choice is capital expenditures — investing in equipment. The money could also be used for mergers and acquisitions. Or buybacks.
2) The tax code is very complicated. Most corporations don't pay 35 percent. Thompson notes the effective tax rate is closer to 29 percent. Some pay far less. Some have very aggressive tax efficiency (or tax avoidance) strategies. So if the effective rate goes to 15 percent, will those who pay far less pay even less? Will we have some companies end up paying, say, 3 percent?
No one knows, at least not yet. There will likely be some minimum required. And this was supposed to be done in conjunction with the closing of some loopholes.
You get the point: It's not clear we are going to get a cut of this magnitude, and a cut is not all going to go to the bottom line.
Thompson freely acknowledges this, but insists the impact is still significant: "The truth is somewhere in the middle, but no matter what there will be some kind of earnings boost from a tax cut," he told me.
Does this mean the market is going to keep going straight up? Thompson is staying clear of any claims: He and his teams are "not suggesting that the stock market is about to immediately experience gains that come anywhere near the hypothetical examples just presented, we only mean to illustrate the potential significance that the discussion surrounding corporate tax reform could have on investor psychology and the level of 'animal spirits' within the broad economy and financial markets generally."
It's still pretty vague, but at least we are putting some flesh on the bones.
The stock market right now is overbought but poised for multiple expansion.
Stocks are expensive now, trading at nearly 17 times earnings expectations for 2017, well above the 10-year historic average of 14.3, according to FactSet.
Are they worth the high price? The market has floated to new highs — and a higher multiple — based on the belief that the United States will have a period of stronger economic growth due to tax cuts, fiscal stimulus and fewer regulations.
Can the bulls pull this off? Can they convince an investing public that has been suspicious of any rallies for years to buy into a sunnier outlook for stocks?
Caterpillar appears to be telling market bulls: Not so fast.
The equipment maker has just fired a shot across the bow of all the traders who have rushed to buy up stocks based on the vague notion that 2017 earnings will be significantly higher for the following reasons that have largely to do with the incoming Trump administration:
1) There will be tax cuts;
2) There will be fewer regulations, and;
3) There will be a massive stimulus program.
Because of this mental gymnastics, the stock market has become expensive. Shares are now trading at close to 17 times 2017 earnings, well above the historic 10-year average of roughly 14.3, according to FactSet (You can read more about this in my note from yesterday here).
Along comes Caterpillar, which was presenting at the Credit Suisse Industrials Conference. They note that while the company is "encouraged by the potential of a U.S. infrastructure bill, tax reform, smart regulation, commodity prices and the recent OPEC announcement," the current 2017 consensus earnings estimate of $3.25 is "too optimistic considering expected headwinds."
What might those headwinds be? They note, for one, that at $38 billion, 2017 sales will likely be about $1 billion lower than the 2016 outlook.