Good News...For Now

​By Brad Thomason, CPA
  
A recent article in the Wall Street Journal commented on how the tax overhaul was playing a role in record corporate profit growth.  That was a fairly predictable result of the new legislation, and it is always kind of nice when everyone gets what they were expecting.
 
The article noted that after-tax earnings were on track to rise 25.3% this year.  That’s a pretty healthy jump.
 
But it’s also more or less what you would expect if you do the math on the tax rate changes.
 
Which raises the question: wouldn’t we like to see earnings growth fueled by something other than a tax break?  Like selling more goods and services at higher profit levels?
 
All earnings growth is probably good, in its own right.  But when it comes as the result of a rule change, that’s a one-time event.  The company gets to keep more money that it would have, and nothing changes that.  It’s a good thing.
 
But you have to remember that a company and its stock are actually two different things.  They’re connected, obviously.  But they are separate.
 
Earning more money is good for the company.  Typically, it’s good for the stock.  But if we look at how the market reacted right after the tax bill passed, and how it is reacting right now as these big profit numbers are being handed in, what we see is that there’s not much credit being given beyond what was handed out back around the end of last year.  So when you see that kind of thing, it’s natural to wonder why.
 
One possible answer is that the market is focused on what I already mentioned: it’s a one-time bump.  A step function, if you will, which represents a permanent increase, but not something which will be a stand-out in future years.  Just the new normal.
 
A second possibility has to do with how current values are always measured against past results.  Could it be that market watchers are already realizing that a year from now when they do this exercise again, the comparisons aren’t going to look so good if nothing else shows up between now and then to drive real EPS growth?  Even when companies are earning profits (a good thing), if they don’t show increases from one year to the next, the price of their stock often falls (a bad thing - which is what I’m talking about when I say the company and the stock are different).
 
Or maybe, they are considering that these headline grabbing gains, being tax-driven, are overshadowing a weakness which would otherwise stand out like a sore thumb.  If the primary reason they went up is because of the tax bump, that actually means that the growth in earnings which has been on a good clip for several quarters, actually came to an end in Q1.  You just couldn’t tell because the tax effect was working its way through the pipe.
 
If that’s the case, it leads you to wonder what actions they might take as a result of that realization.
 
Which is basically where the article ends, by the way.  An eventual acknowledgement that right now especially, might be a good time to look at not just the quantity, but the character, of earnings.  It concludes:  “The lower tax rate could be masking deteriorating fundamentals.”