“People are trying to be smart. All I’m trying to do is not be idiotic,

but it’s harder than most people think.”

– Charles Munger, Vice ChairmanBerkshire Hathaway

My ThoughtsA seasonal financial newsletter from Thomas R. Berry, CIMA, ChFC

April, 2017

2 BerryWealth

April 2017 3

It might feel strange to be the only teetotaler at a party—

that is, unless you’ve spotted Jim Jones behind the bar. In the same way, it may not

be fun to feel like the only investor who’s turning down the bullish Kool-Aid during

this stock market rally. After all, loading

up on equities looks both rewarding

and low-risk these days. But, just like

at a party, everything can go radically

downhill once the bad punch takes

effect.

Nobel Prize-winning economist Robert

Shiller told Bloomberg magazine that the

last time he heard investors talk like they

are talking now was in 2000, and we all

know the “party” mentality ended badly

for the bulls back then. Shiller—who

foresaw both the dot-com bubble and

the global financial crisis—summed up the root of the current euphoria: “This time a

‘Great Leader’ has appeared. The idea is, everything is different.”

Behavioral scientists have found that a broadly shared narrative—whether accurate

or not—can have a powerful effect on economic behavior.1 For example, many

people still base their spending and investing habits on their belief that the Great

Depression was caused by the stock market crash of 1929.1 Research shows “…the

story about the start of the depression is especially powerful and long-lasting, due to

the suddenness and severity of the selloff, focusing public attention on a crash as never

before in America. The narrative of the crash of 1929 was so strong that it persists today.” 1

Yet, the fact is that the Great Depression really began with a recession in 1926. No

matter how I try to reassure some clients that corrections are not crashes, and that

crashes usually start with recessions, they can’t shake their lifelong beliefs.

“The idea is, everything is different.” – Nobel Prize-winning economist Robert Shiller

Jim Jones, 1977By Nancy Wong (Own work) [CC BY-SA 4.0 (http://creative-commons.org/licenses/by-sa/4.0)], via Wikimedia Commons

4 BerryWealth

Market performance tends to be strong, as well, following peaks in business

confidence. Figure 2 shows the five most recent spikes, and Figure 3 highlights what

happened to S&P 500 returns after each one.

Executive confidence peaked in 1983, 1992, 2003, 2004 and 2011.

Donald Trump is a master of narrative, which made his campaign rallies such euphoric

events. Many pundits agree that the most powerful of his narratives is that he will

fix all our economic woes by cutting taxes, slashing regulation, and turbocharging

growth with a trillion-dollar infrastructure boom. One group that seems to be

firmly on board is small business owners. The National Federation of Independent

Businessmen regularly surveys the optimism of its members, and Figure 1 shows how

closely the results tend to track with GDP growth. In other words, optimism is good for

our economy.

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NFIB Small Business Optimism

GDP: Real YoY Change (rhs)

Source: NFIB Small Business Economic Trends, Jan 2017. FRED data, March 30, 2017

Look how sharply optimism increased after the election!

Figure 1. Small business optimism reflects GDP growth

Figure 2. Peaks in CEO confidence

Source: Conference Board as of 1/31/2017, Measure of CEO confidence

Ind

ex

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801980 1984 1988 1992 1996 2000 2004 2008 2012 2016

Peaks in CEO confidence1

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April 2017 5

S&P 500 returns after peaks in confidence survey data

(1) 6/30/1983

(2) 6/30/1992

(3) 9/30/2003

(4) 3/31/2004

(5) 3/31/2011

Average

Average ex. 2004

49.21%

33.47%

34.13%

26.16%

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36.84%

CumulativePerformance

3 years out

80.83%

64.31%

53.29%

17.45%

55.97%

54.37%

63.60%

SurveyData Peak

CumulativePerformance

4 years out

Source: Bloomberg as of 11/30/2016

Figure 3. S&P returns after peaks in CEO confidence survey data

High confidence seems to lead to impressive S&P returns.

So, what’s wrong with your advisor? Why haven’t I jumped on the bandwagon and

allocated more equities to your account? Isn’t this a bull market, after all?

First, as I have written in previous newsletters, US equities are very expensive on

a historical basis (remember those P/E ratios?), so corporate earnings must increase

substantially—and hopefully soon—in order to stave off a major drop in stock values.

Second, I worry that investors seem unwilling to consider the downside risks of

the Trump plan. As Shiller wrote in his latest academic paper:

History does not suggest that even a politician as skilled as Trump can actually

control the progression of the narratives he created. The manner in which these

narratives unfold will play an important role in any economic forecast. To best

predict economic activity, we need, among other things, to watch the narratives

and ask: how will the emerging twists in the narratives affect propensity to spend,

to start unconventional new businesses, to hire new employees? In short, how will

the animal spirits be affected? 1 (See my “Tinder” newsletter for a definition of

animal spirits.)

My point is that Congress is just one of the many forces that can derail parts

of the plan or substantially warp the intended outcomes. Remember, George

H. W. Bush was denied a second term by someone focused on the mantra “It’s

the economy, stupid!” Congress may prove to be less focused, which could have

unpredictable consequences for the current narrative.

6 BerryWealth

Growth is the Holy Grail

The goal of the Trump economic plan is to supercharge our economic Virtuous Cycle

(Figure 4).

At its most basic level, economic growth is all about selling more “stuff.” The stimulus

will offer a mountain of money to buy cement and hardhats and stuff, so companies

will start selling more stuff, so they will have to increase manufacturing, so they will

have to hire more workers and pay them more, so workers will have more money

to put back into the economy by buying more stuff. And in the process, corporate

earnings will get more in line with what they should be to justify current stock prices.

We need to take a hard look at each element of the Trump plan and

assess how likely it is to contribute to this Virtuous Cycle.

Element 1: Cut Taxes

There are three types of tax cuts in the proposal: lower corporate rates, a partial

amnesty for repatriated profits, and lower personal rates.

More Employment – Higher Wages

MoreManufacturing

Increasing Economic

Growth

IncreasedSale of Stu�

VirtuousCycle

Trump’s challenge is to jump start the cycle so it spins like a washing machine.

Figure 4. Virtuous Cycle

April 2017 7

a) Lower rates for corporations

The administration has proposed a top corporate income tax rate of 15% (which I

support). The current rate is 35%, which is the “statutory” rate that corporate tax critics

most often cite. But the corporate tax rate isn’t what it seems. Last year, CNN analyzed

the taxes paid by S&P companies for 2012:

…most large corporations—and about a third of small corporations—did owe

corporate income taxes that year, to the tune of nearly $268 billion. For tax years

2008 through 2012, large profitable companies paid, on average, about 14% of their

pretax income in US corporate income taxes, or 22% once foreign, state and local

taxes are included. That’s well below the 35% top corporate income tax rate.

S&P’s Investment Strategy Group prepared an analysis (fig. 5) of the increased earnings

that a tax cut could provide to corporate America.

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Data as of December 31, 2016. Note: The current US effective tax rate for the S&P 500 companies is 33.3%.

Source: Investment Strategy Group, Standard & Poor’s

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910

1112

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Estimated Incremental S&P 500 Earnings per Share by Tax RateProposals for lower corporate tax rates could lead to higher earnings

Figure 5. Estimated incremental S&P 500 earnings per share by tax rate

But not so fast! The chart’s rather simplistic formula may not hold true in the real

world. Can we be sure that a tax cut will be a positive for the stock market? The well-

respected money manager GMO argues, “It is possible that it will be, but it is neither

theoretically clear that it should be nor empirically obvious that tax rate changes have

been particularly important to profitability.”

It says if we cut the rate to 20%, earnings would increase from roughly $90 per share to $104. That could be great for the market.

8 BerryWealth

Look at Figure 6, which shows corporate tax rates and after-tax corporate profits since

1947. GMO concludes:

It’s hard to see a lot of correlation here. While tax rates are currently at about their lowest

levels and corporate profits just off of their highest, tax rates did their falling in the 1980s

and the profit spike was a good 20 years later. Given that lag, it strains credibility to

argue that the tax rate fall was an important driver of the rising profitability.

If and when tax reform passes, Wall Street analysts will begin raising earnings growth

estimates for individual companies but not for the market as a whole. The reason:

only those who actually paid taxes will get a bump, and around half of the companies

in the S&P 500 Index are currently losing money. Many companies have other ways

of avoiding federal taxes. I read that General Electric earned $21.5 billion in 2010 and

received a $3 billion federal tax refund.2 (I am personally hoping for similar treatment.)

Figure 7 shows the bigger picture of how the growth in our economy has behaved

over time alongside changes in corporate rates. There doesn’t appear to be any cause/

effect relationship.

7%

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Figure 6. Profit growth and corporate tax rates, 1947 – 2013

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Real GDP growth E�ective rate on capital incomeStatutory rate

Economic growth and corporate tax rates, 1947 – 2010Figure 7. Economic growth and corporate tax rates, 1947 – 2010

Profits don’t seem to correlate with corporate tax rates.

Economic growth doesn’t correlate with corporate tax rates, either.

April 2017 9

Would cuts to corporate rates contribute to the Virtuous Cycle?

Not at all guaranteed.

b) Lower rates for repatriated profits

In 2011, the New York Times reported:

Some of the nation’s largest corporations have amassed vast profits outside the

country and are pressing Congress and the Obama administration for a tax break

to bring the money home.

Apple has $12 billion waiting offshore, Google has $17 billion and Microsoft,

$29 billion.

Under the proposal, known as a repatriation holiday, the federal income tax owed

on such profits returned to the United States would fall to 5.25 percent for one year,

from 35 percent. In the short term, the measure could generate tens of billions in tax

revenues as companies transfer money that would otherwise remain abroad, and it

could help ease the huge budget deficit.

Corporations and their lobbyists say the tax break could resuscitate the gasping

recovery by inducing multinational corporations to inject $1 trillion or more into the

economy, and they promoted the proposal as “the next stimulus” at a conference

last Wednesday in Washington.

“For every billion dollars that we invest, that creates 15,000 to 20,000 jobs either

directly or indirectly,” Jim Rogers, the chief of Duke Energy, said at the conference.

Duke has $1.3 billion in profits overseas.

Trump and the Republicans favor a onetime reduced tax of 10% on earnings that US

companies currently hold offshore. It is again being argued that this amnesty program

would eliminate the incentive for US companies like Apple, who now has $183 billion

overseas, to avoid paying high US taxes on their foreign earnings. Proponents promise

the money will be plowed into US capital spending. Let’s look at what actually

happened the last time we tried this.

In 2004, the Homeland Investment Act (HIA) provided for a one-time tax holiday on

the repatriation of foreign earnings by US-based multinational enterprises as part of

the American Jobs Creation Act. Members of congress argued that it would create

more than 500,000 jobs over two years. Analysts at J.P. Morgan Securities estimated

that businesses would increase capital spending by 2% to 3% over two years.

10 BerryWealth

According to the Bureau of Economic Analysis,

U.S. multinationals repatriated about $300 billion in 2005 after the HIA was passed,

up sharply from an average of around $60 billion over the previous five years. The

BEA’s study...revealed that the tax holiday did not have the effect promised. Instead,

the estimates imply that every extra dollar of repatriated cash was associated

with an increase of $0.92 in payouts to shareholders, largely in the form of share

repurchases.

In fact, the companies that took advantage of the program eliminated 52,000 jobs

in 2005. According to the BEA’s analysis, “Sixty percent of the benefits went to just fifteen

of the largest United States multinational companies—many of which laid off domestic

workers, closed plants, and ultimately shifted even more of their profits and resources

abroad.”

The tax break did provide the Treasury with a quick shot in the arm. For example,

Merck brought back $15.9 billion and paid $731 million to the IRS. All told, companies

brought home $312 billion in 2005 and paid $16 billion in taxes. Those numbers would

presumably be much bigger now.

It is doubtful that repatriated profits would have any effect on US growth, capital

investment, or employment. (And one has to wonder if we’ve now taught US multi-

nationals to keep their profits overseas until they’re rewarded with a special tax cut.)

But if it happens, and the money is used for share buybacks, it could have a positive

effect on the share price of participating companies and would likely be good for your

account.

Would cuts for repatriated profits contribute to the Virtuous Cycle?

Doubtful.

c) Lower rates for individuals

Approximately 70% of our economy rests on what individual people purchase

(consume), and much of that consuming is done by middle and lower-middle class

people.3 This huge chunk of the economy cannot expand unless these folks have

more money to spend. For most in the middle class, there are only a few paths to

higher consumer consumption: earn higher wages, earn higher investment returns, go

into debt, or pay fewer taxes.

What if the US economy experienced a recovery but the middle class couldn’t

participate? That’s what President Trump and Congress need to work hard to

avoid. Even with the recent strengthening of the jobs market, the outlook isn’t very

April 2017 11

promising. Wages remain stubbornly low. Equity markets have been on a bull run for

the last five years, but the economy has been sluggish at best for the vast majority

of Americans. Stock ownership is increasingly concentrated in wealthy hands, while

the middle class retrenches. The big returns that hedge funds, real estate trusts and

venture capitalists receive are simply outside the reach of the vast majority.

“Since 52% of American households pay no federal income tax, cuts almost entirely benefit the

well-to-do, and Trump’s proposals are aimed at that group.” 4 The problem is that high-

income people don’t alter their spending habits much when their net worth increases,

so even huge tax cuts for the wealthy will have little effect on the economy. The middle

class is the primary group who would likely spend any newfound income and grow our

economy in the process.

Would cuts to individual rates contribute to the Virtuous Cycle?

Yes, but ONLY if they benefit the middle class in a meaningful way.

Element 2: Slash Regulation

“I’m cutting 75% of regulations, maybe more!” – President Trump, January 23rd, 2017

Regulations can be well intended but often not well received. We want assurances

that our food is safe, that our water is clean, and that unscrupulous people and entities

won’t harm or cheat us. However, the translation of these worthy goals into specific

language can create unintended consequences and can place expensive burdens on

businesses, resulting in a drag on the economy.

Cutting regulations is difficult, both legally and logistically, because one person’s

burden is another person’s protection. And every time our government sets out to

solve a serious national problem, it’s not surprising that the solution is usually big

and complex. Our response to 9/11, for example, was to create the Department of

Homeland Security and to put thousands of officers in airports all over the country.

Our response to a devastating financial meltdown was the Dodd-Frank Wall Street

Reform and Consumer Protection Act, which is aimed at curbing fraud and reckless

speculation. The reality of the rules, however, is that a cost/benefit analysis is sorely

needed in some cases.

According to economist A. Gary Schilling,

The only significant federal agency to be eliminated in decades was the Civil

Aeronautics Board, which set airfares, route by route, and even controlled the

meals that could be served on airplanes. Still, competition found its way around

12 BerryWealth

regulations. On the New York-to-Chicago run, only sandwiches could be served. So,

airlines competed to see how much could be stuffed between two slices of bread,

even whole chickens!

Both corporate earnings and the economy as a whole will probably gain in the short

term from cutting regulations. (Fish may start sprouting 3 eyes and two tails, but

what the heck.) The right-of-center Heritage Foundation noted in a recent study

that 229 major regulations have been passed since 2009. (To be categorized as a

major regulation, the rule must cost consumers and business over $100 million.) They

calculated the cost of these 229 regulations at $108 billion. Other organizations, which

use a lower dollar hurdle, have come up with around 600 rules costing $800 billion.

Corporate profits are forecast to be $1.6 trillion in 2016. If the president eliminates

75% of the Obama-era regulations, reducing the cost of compliance and making

processes more efficient, a short-term bump to corporate earnings seems inevitable. If

corporations increase profits by just $100 billion, that could increase profits by 6.25%.

No legislation is needed in many cases to change or eliminate a rule, and the positive

effects would be felt immediately as costs disappear from Profit & Loss statements.

Regulations which have been passed by Congress have their own constituencies,

which probably means it would take much longer to deregulate those areas.

(Note: There are obviously other sides to this issue.)

Would fewer regulations contribute to the Virtuous Cycle?

Likely yes, in the short term.

April 2017 13

Element 3: Turbocharge Growth with a Stimulus Package

In order for a giant stimulus package to work, it must purchase a huge quantity of “stuff”

from American businesses and boost corporate earnings in the process. (Interestingly,

it doesn’t work to just give each citizen cash; last time we tried that most of the money

was either intercepted by the IRS or was used to pay down consumer debt.) Along with

middle class tax cuts, infrastructure and military spending are the administration’s best

hope for reaching their lofty goal of 4% annual economic growth.

Why 4% GDP growth? At that rate, corporate earnings could soar. Not only would

current stock prices be more fully justified by historical standards (lower P/E ratios),

but returns would likely be excellent as well. Fortune magazine did the math and

concluded: “…at the end of our eight-year window (Trump’s tenure as president), the

market needs to deliver 15% a year in annual (corporate) earnings to deliver an 8% return” to

shareholders.

Unfortunately, earnings haven’t grown that fast during any eight-year period since the

end of World War II. By comparison, we had good news recently regarding the first

quarter of 2017; the estimated earnings growth rate for the S&P 500 looks to be 9.0%. If

9.0% is the actual rate for Q1, it will mark the highest (year-over-year) earnings growth

for the index since Q4 2011 (11.6%). It’s good, but it’s a long way from 15%.5

What about 3% GDP growth? Warren Buffet says that something magical happens to

corporate earnings when the economy grows by 3%. Historically, a rate of 2% or lower

has smothered corporate profits, so after a ten-year run of approximately 2% GDP

growth per year, we need a 3+% rate in order to get corporate sales to take off.

What the curmudgeons think. The US economy is developing a

natural momentum of its own. We

may be on a bumpy ride, but the

economy will not be derailed. Initial

unemployment claims are at a 30-year

low, manufacturing is increasing, and

sentiment is rising.

Yet, despite recent improvements, both the Federal Reserve and the nonpartisan

Congressional Budget Office (CBO) are still skeptical of reaching a 3% growth rate

right away. The CBO foresees 1.9% per year between 2021 and 2027, and the Federal

Reserve expects 1.8% annually in the long run. These differences aren’t trivial. Growth

of 3.5% vs. 1.8% per year would make the economy 18% bigger a decade later. It

14 BerryWealth

would also reduce federal budget deficits as personal and corporate incomes go up

and the need for programs like food stamps and unemployment benefits goes down.

Many economists believe the president’s 4% GDP growth forecasts were compiled

by a staff member named Ms. Rosy Scenario. Somewhat more attainable is Warren

Buffet’s magical 3%. We shall see how well Trump and Congress can execute this

critical play.

Would a stimulus package contribute to the Virtuous Cycle?

Absolutely, but the timing and full impact remain to be seen.

My Economic Forecast (it’s my newsletter, after all)

I continue to believe Trump’s stimulus package will cause a one- to two-year “coke”

acceleration (sugar high) starting in 2018, after which the economy will slow again for

several years after the stimulus wears off. Figure 8 is the graph I created for the Trump

newsletter in December. (Check it out for more on Fed Chair Janet’s Yellen’s views.)

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wait coke diet coke red bull

Figure 8. Tom’s GDP growth predictions

I will also reiterate my previous warnings about risk in these volatile times. Unless and

until the stimulus kicks in, the Trump Bump in overvalued stocks remains a danger to

shareholders. The president and members of Congress need to support the narrative

that they are on track to do what they’ve promised. Otherwise, investors may get

spooked and trigger a painful correction. This is just one of the many reasons we need

to be clear-eyed about the risks inherent in the market today.

April 2017 15

The word “risk” has taken on a purely theoretical connotation in recent years, to the

extent that it is now seen as equivalent to “return.” Investors are likely to rediscover

that its actual meaning is quite distinct, and devastatingly real.

When Speculators Prosper Through Ignorance

John Hussman Ph.D.

President, Hussman Investment Trust

At this point, many of us think we understand the Trump narrative and what it entails.

Based on those expectations, huge sums are being invested by people who are

betting on the message and its timeline. Yet, as I quoted Professor Shiller in the intro,

detours in the narrative—and even in the timing of its execution—can have huge

effects on outcome. I think there’s a real chance we could see Ms. Rosy Scenario’s 4%

growth in a year or two, but it’s by no means assured.

Because you know my sense of humor (sophomoric) I’ll close with my favorite story

about a misinterpreted narrative. As a teenager, I went with some buddies to see

a comedy about a foreigner who was struggling to understand our culture and

language. I don’t remember the title, but I do remember the scene where the guy,

having misunderstood an invitation to a “black tie only” dinner, showed up wearing—

you guessed it—a bow tie and nothing else. My friends and I actually got thrown out

of the theater because we were laughing so hysterically, and we were still in stitches

out on the sidewalk.

As investors, we could find ourselves wearing nothing but a bow tie in a market

downdraft if we misinterpret the ways that Trump’s economic narrative plays out over

time. (If you’re looking for a cartoon of me in “black tie only”, forget it.)

It’s an enormous plan with innumerable moving parts. We will do our best to monitor

its progress so you don’t find yourselves unprepared for the party, whatever it

eventually looks like.

Thanks for your trust and for taking time to read this newsletter.

PS: In case you’re wondering if my movie tastes have evolved, I love “Dumb and

Dumber” but feel that the plot is a tad weak in “Dumb and Dumber To”.

April, 2017

16 BerryWealth

One SW Columbia St., Suite 650, Portland, OR 97258 p: 503.546.3200 l f: 503.546.3205 l www.berrywealth.com

Securities offered through LPL Financial l Member FINRA/SIPC

Notes:

1. Robert J. Shiller, “Narrative Economics,” Cowles Foundation Discussion Paper No. 2069.

2. David Kocieniewski, “G.E.’s Strategies Let It Avoid Taxes Altogether,” New York Times, March 24, 2011.

3. St. Louis Federal Reserve, FRED Publications, January, 2015.

4. A. Gary Schilling, “Insight Newsletter,” March, 2017: p. 6.

5. FACTSET, “Earnings Insight,” March 7, 2017.

Disclosures

The economic forecasts may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Market commentary and analysis mentioned here should not be used to make investment decisions.

Securities and investment Advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC. Berry Wealth is separate from LPL Financial and is not a broker dealer.

©BerryWealth, April 2017

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