The market could be 'in the crosshairs’ of a 20% drop if tax reform fails

• It's no secret that the expectation for tax reform has driven the market rally.
• Adding ACA repeal to tax reform is 'a distraction' that could kill the bill.
• Failure to pass reform could lead to a 10 to 20 percent market drop.

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Being a product of the late seventies and early eighties, I saw first-hand the impact tax reform can have on a faltering economy. Entering college in 1979, the dark days of Jimmy Carter left us with high inflation, high interest rates, high unemployment and low job creation. Worse yet, instead of investing in new ideas, capital went into ways to shield income from ridiculously high taxes.

Though the economy is in better shape today, students of the market know that tax reform is an absolute must if the market rally is to continue. There are three critical components we must focus on: Time, momentum and value.

We're running out of time. It's unfortunate that the Republican controlled congress did not act on tax reform before trying to tackle Obamacare repeal. The distractions have left little time for republican leadership to create a package acceptable to its own members, let alone others from across the aisle.

The latest attempt by the Senate to include repeal of the Affordable Care Act in the tax reform bill has left legislative print in jeopardy. What was supposed to be the first real reform in 30 years is in the process of being watered down, and even worse, the end product could be unpassable. ACA repeal must be separated from the reform package or it could fail. Repealing the ACA is a distraction, period.

During the Reagan years the highest tax rate had been slashed from 70 percent in 1981 to 28 percent. Reagan's tax cuts didn't take full effect until Jan. 1, 1983. In 1981 and 1982 GDP suffered as corporate America waited to unleash its spending and hiring power. In those early years we saw negative growth and lackluster job creation, but then something happened…animal spirits kicked in. Average annual real GDP growth for the years 1983 through 1989 was 4.4 percent.

The market knows that phasing in any reform will most likely be treated the same now as it was back then. Under Reagan, the market ran up in anticipation of lower taxes and deregulation but the delay in implementation caused a selloff in 1981 and '82, taking stocks down nearly 20 percent.

Regardless of how the negotiations between the Senate and the House unfold, the stock market might be ahead of itself now, just like the early 80's. At a minimum, the rally has lost some momentum and is now looking for a signal which will allow for more risk exposure. Tax reform is in and of itself the most important thing this congress can do for the economy, and it's the only way to keep the market momentum moving forward.

Let's be clear: The market is at an all-time high now because of two things, the anticipation of tax reform and a healthy business climate. Deregulation and being 'business friendly' is only a small part of the equation. Tax reform is the 1000-pound gorilla which everyone knows they want, but more importantly, need.

The present value of the market is around 17 times the P/E of the S&P. Earnings are good, and CEO's seem optimistic. But what if that optimism is scared away by legislative dysfunction? One might argue that spending will slow, earnings will suffer, and GDP will be stagnant such as it was in the early eighties. If reform is delayed, look for CEO's to slow spending and wait for tax clarity. Earnings can suffer and that will put the present P/E much higher than the one trading today.

The untold story of the 1980s and '90s was one of upward economic and social mobility. After-tax incomes of middle-class families rose by roughly 30 percent from 1982 to 2005. Between 1982 and 2000, the Dow would go to 11,000 from less than 800, the nation's net worth would quadruple to $44 trillion from $11 trillion, and the US would produce nearly 40 million new jobs. Federal tax collections rose from $500 billion in 1980 to $1 trillion in 1990.

But to get back to that kind of growth we need congress to act, and act fast! It's getting to the point where the probabilities of constructive corporate tax reform this year are getting smaller by the day.

Stocks hit a wall last week when talk of the delay in corporate reform was revealed. The flattening of the yield curve over the last few months (which usually predicts a slowdown) is a big red flag. It's no secret this recent run up in stocks is dependent on the passage of reform. If our legislators don't act by year end, stocks could be in the crosshairs of a 10 to 20 percent correction.

Commentary by Jack Bouroudjian, CEO of Index Futures Group LLC, a registered independent broker, and CIO of Index Capital Partners, a registered commodity-pool operator. He was also a three-term director of the Chicago Mercantile Exchange and founder and advisor of UCX (Universal Compute Exchange). Follow him on Twitter @JackBouroudjian.

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