Monetary and fiscal policy will be in the spotlight this week. The FOMC meets Tuesday and Wednesday but no significant changes in monetary policy are expected. Federal Reserve Chairman Jerome Powell’s Wednesday afternoon statement will be followed by President Joe Biden’s first major address later that evening. Biden’s first appearance to a joint Congress takes place on the eve of his 100th day in office. Although newly inaugurated presidents typically address a joint Congress a month after they are inaugurated in January, this administration delayed the address to April due to “complications with the ongoing coronavirus pandemic.”
American Families Plan
Biden’s address will be widely covered, not only because it is his first major speech, but because it will highlight the administration’s American Families Plan, which the financial media expects will detail a $1.8 trillion spending and tax plan. President Biden may focus more on the hundreds of billions of dollars itemized for national childcare, prekindergarten, paid family leave, tuition-free community colleges, subsidies for the Affordable Care Act and other domestic programs. But Wall Street will be listening to hear how this plan will be funded. Most expect about a half-dozen tax hikes on high-income Americans and investors and many of the proposed changes are already eliciting fierce opposition in Congress and on Wall Street.
Keep in mind that this proposal represents the second part of Biden’s “Build Back Better” agenda, and it follows the $2.3 trillion jobs and manufacturing proposal the White House released a few weeks ago. If one includes Biden’s American Rescue Plan Act of 2021, a $1.9 trillion stimulus package which was passed in early March, the three plans total approximately $6 trillion in new spending and would be one of the most ambitious government overhauls of the economy since the Johnson administration.
Capital Gains Tax Hikes
Gathering the most attention and controversy about how the American Families Plan will be financed is the proposed capital gains tax. To finance the proposed spending, the administration hopes to raise the capital gains tax rate for people making more than $1 million from 20% to 39.6%. Note that the Affordable Care Act includes a 3.8% surtax on all capital gains. This would still be in force and would push the real capital gains tax rate to 43.4%. If passed, it would translate into the highest maximum capital gains tax rate in history. See page 3. Unfortunately, what some politicians fail to grasp is that raising the capital gains tax rate rarely, if ever, generates the tax revenue that is predicted. The reason is that tax laws change people’s behavior. Raising the capital gains tax rate may prove to be a boon for tax lawyers and accountants since they will find ways for clients to avoid taxes. Investors will invariably change their investment strategy, shift assets to trusts or move assets out of the US. As a reminder, when the tax laws changed and only made mortgage interest payments tax deductible, investors borrowed against their home to fund colleges, autos, home improvement and other personal loans. Government officials fail to understand this change in behavior. Projected revenue from a tax policy change will rarely be a straight line.
Moreover, a hike in the capital gains tax rate is always bad for stockholders. The reason is that a higher capital gains tax changes the risk-reward ratio for investors, in a negative way. The 39.6% would be the highest rate on capital gains in any global country and this would have a negative impact on foreign investment in the US. This means those who do not make $1 million or more will still be hurt by this potential tax hike. However, most strategists do not believe the bill will pass as proposed. We hope this proves correct.
Housing is On a Roll
March housing data was strong. Although still below the peaks recorded in November 2020, the National Association of Homebuilders’ single-family housing sentiment was generally higher in March. Traffic was the most improved segment of the survey at 75 versus 72 in February. Both new residential permits and housing starts rose in March on a month-over-month and year-over-year basis. Permits hit a record high in January; housing starts reached a record high in March 2021. See page 4. Housing received a big boost in 2020 from fiscal stimulus and stay-at-home restrictions. The massive fiscal stimulus seen in early in 2020 had a direct impact on median existing home prices. See page 5. Housing inventory is currently low, and this lack of supply will continue to support prices in the coming months. New home sales rose 66.8% YOY from a depressed March 2020 level and prices increased 6% YOY. Single-family existing home sales grew 12.3% YOY and prices jumped 11.8% YOY in March. See page 6. However, homeownership hit a cyclical peak of 67.9% in June 2020 and fell to 65.6% at the end of March. And despite the much-touted mass exodus from the Northeast to Florida, the South had the sharpest decline in homeownership, which fell from 71.1% in June 2020 to 67.4% in March. In the same time frame, Northeast homeownership fell merely 0.2%. See page 7. This decline in US homeownership rates is favorable since it implies there is more future demand for housing.
Earnings on a Roll
The best part of the last week has been first quarter earnings season. Early in the year, Refinitiv IBES consensus estimates were forecasting a 14.5% YOY growth rate for the first quarter, but as earnings season progresses, we have seen estimates rising sharply. IBES now assesses earnings will increase over 35% in the first quarter. To date, 85% of companies reporting first quarter results beat expectations. To date, all energy, healthcare, technology, and communications services companies have beaten their forecasts and have had positive surprise factors of 434%, 15%, 12%, and 8.6%, respectively. In aggregate, companies are reporting earnings that are 23% above estimates, which compares to the long-term average surprise factor of 3.7%. This display of earnings power is providing an excellent foundation to the current rally.
Technical Indicator Review
There are good points to the market’s technical backdrop, and this includes the new highs in the NYSE cumulative advance-decline line on April 26 and the new high list which is averaging a strong 477 new highs per day. But higher prices do not impress us if volume is not supporting the advance. The 25-day up/down volume oscillator is currently 1.99 (preliminary) and neutral this week despite the new highs in the popular indices in recent sessions. This indicator was last overbought for five consecutive trading days between February 4 and February 10 which is when many momentum indicators peaked. At present, our indicator is revealing that the indices are moving to new highs on lower volume – a sign of diminishing demand. The longer this persists, the more worrisome it becomes. However, we should point out that prior to the March 2000 peak, this oscillator had not generated an overbought reading since November 1998 (17 consecutive days in overbought). This 16-month period of price advances without confirmation from advancing volume predicted a significant decline. At present, we have a 10-week non-confirmation, which is concerning, but not a sign of a bear market. Sentiment is also problematic. The AAII bullish sentiment for April 21 fell 1.1 points to 52.7% and has been above average for 21 weeks. Bearishness fell 4.1 points to 20.5% and is below average for the 11th time this year. Historically, periods of above-average bullishness and below-average bearishness have been followed by below-average 6- and 12-month equity performances. In sum, there is good news in the earnings backdrop, potentially negative news in the political scenario, and a mixed bag in the technical condition of the stock market. In our view, equities are apt to see a 5% to 10% correction in the second quarter – and this would be the healthiest development for investors.