Is Tax Reform Already Priced Into the US Stock Market?

For the last couple months one of the main topic of discussion on the business news channels (CNBC, Fox Business, Bloomberg) has been the question, “Is Tax Reform Priced in Already”? A lot of pundits think it is, and so there’s not much upside. But many of these pundits, reporters, and portfolio managers have too much faith in the efficient market hypothesis. They tend to think the market prices in all information immediately and almost perfectly. It is true that the market is very good at discounting information, and in many cases by the time an anticipated bullish event happens that a casual observer would expect to make prices go up, prices actually go down. And that is because that information was anticipated and already priced in.

But the market is a price discovery mechanism and takes time to price in information, which is just common sense when you think about it. If you think of the ‘market’ as a bunch of informed individuals who have mostly the same information but different opinions about what that information means, it should be obvious that if you ask them what a given stock is worth their estimates will cover of range of values that will probably look like some type of bell curve with a few extremes a cluster around a certain price. The market probes up and down trying to find an equilibrium price where buyers and sellers are equal, and this equilibrium price is usually where there is a cluster of agreement among market participants. And the market often overshoots the equilibrium price as it is attempting to find it.

If these market participants have very quantitative information (i.e. a company plans to sell 100,000 watches) they can price it in quickly and there probably will be relatively little disagreement about how that information changes the price. But if the market is trying to determine how to price in a major piece of legislation, like the biggest tax reform in 30 years, and that legislation has a number of policy changes that work in combination and are not easy to quantify, then there will be a wider range of opinions about what effects will be and thus a lot of disagreement about a fair price for the market.

Nobody knows how much of the tax cuts will go to increased wages, new investments, stock buybacks, or dividends. Nobody knows whether the tax reform will change the growth rate of the economy or by how much. Nobody knows what effect all the repatriation of overseas profits will have on the dollar. All we know for sure is that the tax rate on companies is going to drop to 21%, and that can be used as a base increase to the earnings of all companies.

So it is logical the market would price in the 21% quickly and efficiently. The big rise in the stock market from August 2017 until the bill was signed into law was probably due in large part to that clear boost in earnings. But what about all the other policy changes and their effect that nobody knows? And by the way, the market didn’t really even know what those policy changes would be until the final bill was passed. The market has to probe upwards to try to find a price where there are more sellers than buyers. Nobody knows what that price is until it gets there and we actually see enough bulls become bearish and sell.

What often happens is that the market moves quickly when it is far away from the equilibrium price because there is a large imbalance between supply and demand. As the market gets closer to equilibrium the imbalance between buyers and sellers is not as pronounced and so the market moves up more slowly and then usually enters a trading range around the equilibrium price.

So is tax reform priced in? How can it be priced in when we don’t even know what the effect will be of the policy changes. That will become more clear as companies tell us how they will use the money and how fast the economy is growing.

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