Wondering what will drive the stock market in the coming months? Here’s a rapidfire roundup of key developments you should watch.
The effect of operating leverage
Operating leverage tells you how much earnings growth a percentage increase in sales generates. In other words, operating leverage is like a profit magnifier (or dampener) For an in-depth, “human” explanation of how it works, read my recent article.
Now, whichever it is depends on whether you make enough sales to cover your overhead. And that often has to do with where in the economy cycle we are.
The positive effect of operating leverage is most visible in the wake of recession. This is when sales recover and businesses break even on fixed costs. For proof, take a look at how a small percentage increase in revenue growth exploded earnings after the 2008 recession:
Wall Street analysts are projecting a similar trajectory of earnings growth this time around. And some of them believe the “explosive” effect of operating leverage on earnings will be one of the biggest surprises in 2021.
MORE FOR YOU
Higher government spending and taxes
Biden is proposing a massive spending plan that he wants to fund by ramping up taxes for big corp and wealthy individuals. In short, his tax reform suggests three sweeping changes:
- Higher corporate tax rate—raise the corporate tax rate from 21% to 28%
- Minimum global tax—impose the global minimum tax on big tech and other multinational companies to end offshoring
- Minimum book income tax—impose a 15% minimum tax on the income of public companies so they can’t exploit loopholes (for example, despite making gazillions of dollars, Amazon AMZN paid 0$ in federal taxes in 2017 and 2018)
- Higher capital gains tax—raise the top tax rate from the current 20% to 39.6%
So while this spending spree bodes well for stocks, they will likely “pay” for it with higher taxes. And some companies will bear a higher toll than the others. (Read this and this article to find out the potential winners and losers)
Higher inflation and rates
Since the onset of Covid, the US has printed over $5 trillion (and counting).
But as I discussed before, a lot of that money hasn’t made it into the economy. Americans have stashed away a good chunk of their checks in savings accounts. And corporate America is still sitting on billions in cash—as you can see below:
Now, investors are hoping that part of this pile will rain down on the economy once Covid is over.
If that happens, the “printed” dollars will finally reach the economy, which in theory will lead to inflation. Inflation (or inflation expectations), in turn, will push interest rates up. And higher rates will make stocks less attractive (broader explanation here).
But make no mistake, that’s not necessarily bad for all stocks. The earnings of companies that benefit from the potential spending boom will likely offset the bad effect of rising rates.
Stay ahead of market trends with Wall Street-grade insights