Nevertheless, the hopes of a tax reform have kept the markets buoyed. How much can these tax cuts add to the markets and what is the risk if the reforms are watered down or just don’t see the light of the day?
The stock markets rise or fall on sentiment, earnings, and economic data. While the initial boost following the US Presidential elections was sentiment driven, the markets held their own as the data flow stabilized and improved in the US and around the world.
However, at the current levels, the US stock markets look pricey compared to historical averages.
Key points
- The markets are trading at rich valuations even after discounting a favorable tax cut
- Treasury Secretary Steven Mnuchin believes market will crash without a tax reform
- A few analysts believe that the markets will remain firm even without a tax cut
- We believe markets will be vulnerable for corrections if Republicans fail to pass the tax cuts
- Buy the rumor regarding tax cuts and sell once the news of a tax reform is announced
Analysts expectations for the S&P 500
The S&P 500 is expected to end 2017 with earnings of $131 per share, increasing about 10% over 2016. For 2018, analysts expect the S&P 500 companies to collectively earn $145.2 per share.
However, there are differing views on whether these figures include the benefits accrued from the tax cuts or not. If the tax benefits are incorporated, then to what extent.
The most bullish analyst on the street, Morgan Stanley’s chief U.S. equity strategist, Mike Wilson, believes that about $9 of $145.2 in the earnings projection is based on the benefits arising out of a tax cut. On the other hand, the most bearish analyst, Weeden & Co.’s Mike Purves, believes that $14 per share is from the tax cuts.
Let’s take a bullish scenario.
Analysts expect the annual per-share earnings to increase by $15 if the corporate taxes are cut from 35% to 20%.
However, Wilson has only accounted for $9 in benefits from the tax cuts. Therefore, we will have to add another $6, which gives us a figure of $151.2.
So, in the most bullish scenario, at 2580, the S&P 500 is trading at a forward p/e of 17 times.
Factset data shows that the 5-year average and 10-year average forward earnings P/E ratio of the S&P 500 is 15.6 and 14.1 respectively. Therefore, even with the most optimistic scenario of earnings built in, the S&P 500 is currently trading above its past averages.
However, just because its current valuations are above the historical averages will not cause a correction in the markets. But, can a failure to pass the tax cuts start a fall?
What if the tax cuts don’t see the light of the day or are diluted in their effect
Again, we shall consider the most bullish scenario. If the Republicans fail to pass the tax reforms, then the earnings projection for next year will fall by $9, to $136.2. At that level of earnings, the S&P 500 is currently trading at a P/E of $18.9, which starts to look pricey.
What level was the S&P 500 trading prior to the two previous crashes of 2000 and 2007?
As seen in the chart sourced from yardeni.com, the S&P 500 is already trading at a higher forward P/E than 2007. This confirms that we don’t have the comfort of valuations behind us. However, we are still a distance away from entering into a bubble territory when compared with the forward P/E of 24, recorded during the heights of the dotcom bubble. Therefore, a crash might not be in the offing.
How much will the S&P fall if the tax reforms don’t go through
Here again, there are two schools of thoughts. While one says that a failure to ring in the tax reforms can easily plunge the S&P 500, others believe that the stock market is unlikely to fall more than 5%.
Treasury Secretary Steven Mnuchin believes that a lot is riding on the tax reforms. In a podcast with Politico he said: “To the extent we get the tax deal done, the stock market will go up higher. But there’s no question in my mind that if we don’t get it done, you’re going to see a reversal of a significant amount of these gains.”
However, Credit Suisse and Morgan Stanley differ, as they don’t see a market crash even if the tax reforms fail.
“The market rewarded firms with high effective tax rates for only three weeks post-election, but not since”, wrote Jonathan Golub, Credit Suisse’s chief U.S. equity strategist. “For that reason, we do not believe that stocks would be at risk if a deal isn’t struck”, reports CNBC.
In a note to its clients, Morgan Stanley has painted three different scenarios with no tax cuts, modest cuts, and substantial cuts.
Morgan Stanley believes that the markets will only fall by 1% if the tax cuts don’t happen.
What do we believe?
We believe that the US market rally in the past year has been driven by hopes of a fiscal boost and tax reforms. These have kept the sentiment positive. As a result, the markets have risen on favorable economic data in the US and around the world and has not given up ground even when the news was unfavorable.
However, after failing to repeal Obamacare, if the Republicans fail to push through a meaningful tax stimulus, the sentiment will be dented.
That will leave the markets vulnerable to sharp drops on any adverse news because the floor of the reforms and an earnings increase will be lost.
On the other hand, if the tax reforms are announced, the markets are certainly likely to surge in the short-term, however, the bump up is unlikely to last for more than a few weeks. Usually, experienced traders buy the rumor and sell the news. We expect the same to repeat once the reforms are announced.
The markets will correct and the focus will shift to the effects of the stimulus at this stage of the recovery, which has been questioned by many economists. The Federal Reserve may also have to tighten at a faster pace than expected, which may neutralize some of the effects of the rate cuts.
Bottom line – To buy or to sell?
Buy the rumor of a substantial tax cut. However, once the cuts are announced, please book profits in the ensuing buying stampede.
On the other hand, if the tax cuts fail to materialize, keep the buy list ready to enter on any fall, which is closer to 8% to 10%.
