As Sam Sees It: What Are Investors to Make of the Tax Cut Situation?

Each week, we tap the insight of Sam Stovall, Chief Investment Strategist, CFRA, for his perspective on the current market.

EQ: There seems to be serious concern that Congress won’t be able to get a tax package done anytime soon. With no other real catalyst in the picture, does this put a damper on the market as we head into the end of the year?

Stovall: Yes, it does, at least for the near term. I think it could end up triggering a pullback if Wall Street thinks that no tax deal will be done at all. My belief is that the carrot offered by a tax cut has been the driving force behind this stock market rally, but it has not shown up in corporate earnings estimates because there’s been no detail.

With that said, it seems as if now with the administration looking to include the repeal of Obamacare with the tax package, it could end up causing another stumbling block. I think it’s certainly going to add to the drama, but I believe that there is still a greater likelihood that a tax cut will be passed rather one failing entirely.

EQ: In this week’s Sector Watch, you covered this topic, and reiterated that CFRA believes the S&P 500 is overvalued by approximately 10%, and such a dip could be triggered if a tax plan is not passed. If somehow a tax package is delivered, what kind of upside could that have on the market? Or is it already priced in?

Stovall: Well, I think some of it is priced in. The reason I say that the market is overvalued by 10% is because I used the Rule of 20—which looks at both P/E ratios and inflation. Using current earnings data combined with current inflation levels, we’re actually about 10% higher than where the Rule of 20 says we should be. But looking toward year-end 2018, there is single-digit upside potential just based on the earnings estimates as they’re seen today. So, I think that some of the optimism of a tax cut is built in, but there could be even greater upside potential, depending on how sweeping that tax cut package ends up being.

EQ: Would there be a meaningful difference to the market if a tax plan is passed before the year is over versus one that is passed sometime next year?

Stovall: If it is passed within calendar year 2017, there is always the possibility that the tax cuts get backdated to the beginning of the year. That certainly would be very helpful to corporations because then they would have less to pay in taxes in the final quarter, and I think it would cause the market to shoot up similarly to what happened after the Trump election.

But I think it’s most likely that we end up with a tax package that is approved at the beginning of 2018, which will benefit 2018 earnings estimates, and therefore be much more meaningful next year in terms of bottom line results, but again, could help support and even propel prices even further.

EQ: If Republicans are unable to put a tax cut in place, which sectors or industry groups could feel the brunt of a potential reversal? Would there be any group that would benefit from the status quo continuing?

Stovall: Well, as I said, since a tax cut is not built into earnings estimates because we don’t know how they would actually apply, we have to look to those sectors that are expected to show the strongest earnings gains in 2018. So, right now estimates are that the S&P 500 will post a 10.6% gain in operating earnings for all of 2018. The double-digit gains are expected to be found in Energy, Financials, Tech and Materials. The lowest earnings growth is expected to come from your usual suspects of Real Estate, Telecom and Utilities.

So, essentially if the stock market is left to pricing itself based on GDP growth, we believe it is going to be good—up 2.8% versus 2017’s estimated rise of 2.3%. Also, larger-cap stocks will outperform small-cap stocks because the tax cut would have benefited the smaller stocks more than large stocks. Plus, if global economic growth is expected to be a shade below 4% next year versus a shade above 3% this year, that too would benefit the multi-nationals more than the smaller-cap domestic stocks. I would tend to say that without a tax cut, we’re still going to see upward trajectory in the stock market through 2018, it’ll just be a bit more muted. It’ll help the large stocks over small stocks, and help the multi-nationals over the more domestic companies, and would appear as if the cyclical sectors are going to do much better than the defensive ones.