Republicans Wishing America: Happy Holidays! (?)
The holidays have arrived! Retail spending is up, unemployment is down, and travelers look to be hitting the roads this season in record numbers. And it now appears that corporate and personal tax cuts will be arriving in 2018 despite last-minute demands in the Senate from a couple of potential holdouts. Investors have responded, as evidenced in trading patterns over the last few weeks which have been tracking the shifting political winds. This leaves two questions: first, is the tax cut now fully baked into stocks, and second, how much will tax policy guide investing strategy through the course of 2018?
Investors have been reacting to the negotiations, as some stocks have risen as the probability of a cut to the corporate rate has climbed. Sector rotation has begun as investors do the tax-cut math, and the technology sector has been one of the larger sources of cash. The Philadelphia Semiconductor Index (SOX) has fallen over 5% since late November. The obvious beneficiaries of a lower corporate tax, such as retail stores with effective tax rates as high as 39%, have seen share appreciation of nearly 10% since shortly after Thanksgiving when the Senate negotiations began in earnest. But a broader measure of tax-cut driven increases, the Goldman Sachs basket of high tax stocks (GSTHHTAX), has climbed only 4% in that time. And that group of companies has badly underperformed both the S&P 500 and a low-tax basket of stocks over the course of 2017.
Even though tax reform now appears slated for 2018, the 1,100-page document leaves plenty of complexity in the tax code for corporate accountants to sort out. And if the accountants do not yet know how the various changes will impact tax obligations for 2018 and beyond, investors will have an even harder time sorting the big winners from the small winners, and assessing all the ones at the back of the pack. So look for more adjustments to come; investors have just begun to assess the implications of tax cuts and we’ve seen only a small response in stocks thus far.
Since lower tax rates will boost earnings per share for many companies in the S&P 500, stock prices need to move higher by a commensurate amount or P/E multiples will fall. Some companies are likely to see after-tax profits increase by as much as 35-40%, while other companies will see negligible gains. And those which have paid little in U.S. taxes in the past may miss out entirely or even face a higher tax burden. Our estimates place resulting average share appreciation for S&P 500 stocks in the neighborhood of 8-12%, as compared to the 4% average gain in high-tax stocks thus far. And that 8-12% average increase includes much higher gains for companies paying among the highest effective tax rates, and little-to-no benefit for companies at the low end of the spectrum. By this calculation, the meager response we have seen thus far, after a long year of underperformance, leaves shares in higher-tax-rate companies with more room for appreciation.
Importantly, a change in tax policy merely changes the level of earnings, rather than the growth rate, as companies experience a one-time adjustment from the old tax structure to the new tax rates. The resulting adjustment in valuations should arrive relatively swiftly once the complexities of tax changes for each company are sorted out. Beyond that, companies whose shares are likely to outperform will be those which can deliver more promising earnings growth prospects. Analyst forecasts currently indicate that we are likely to see continuing earnings growth from energy, materials, info tech, consumer, and financial sectors next year. And those growth forecasts are being driven not by tax cuts, but by expansion in end markets, strengthening of pricing, or reductions in costs. These fundamental growth drivers can last for multiple years, unlike the one-time boost from a tax cut. We have been positioning for the tax cut, but are also continuing to find value investing opportunities for 2018 and beyond in leading growth sectors, including energy (as that sector continues to recover), info tech (as that sector continues to grow from investments in cloud, security, and broadband), and financials (as interest rates move higher).
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