Bull and Bear Case For Earnings

As I mentioned in a previous article, earnings estimates vary widely. Anything can happen in a sense. The bull case before the election was that margins would increase to record highs. With the Trump tax cuts potentially in place, there are further tailwinds to earnings rising quickly. On the bear side, earnings estimates have been missed throughout this recovery. Given that 2017 GDP growth is starting off with a whimper, that doesn’t bode well for earnings this year. While tax cuts may occur, there hasn’t been a clear path for a plan to pass Congress yet. It has been 100 days and all we’ve seen is a one page proposal which has guidelines which were laid out months ago. The fact that there’s a low probability that the government can shut down shows how disoriented Washington D.C. is now. That’s not a political statement. The reason the tax code and healthcare system need reform is because politicians for decades haven’t been able to solve the problems.

The chart below summarizes the bearish case for earnings quite well. As the saying goes, ‘fool me once shame on you, fool me twice shame on me.’ In this case earnings estimates have fooled investors multiple times. The correct description is willful ignorance. Investors on Wall Street want to keep the party going, so they are willing to plug optimistic estimates into their models even though they keep missing the mark. It’s not like it is one analyst making wrong predictions. The consensus has been wrong. Even though it has been wrong, it’s not easy to ignore them. The endless cycle of predicting great future results never deals with reality because after bad results are reported, they are already in the past, making them not matter to these ‘forward looking’ investors. This doesn’t mean investors should stop forecasting future cash flows; it means being realistic should be the goal.

The chart below shows what the S&P 500 would be at using a 15 multiple on various earnings estimates. Stocks barely fell even though there was an earnings recession. Each successive estimate falls but stocks keep rising. It makes you question the entire perspective of this article. I’m discussing whether earnings will rise or fall, but those who predicted the earnings recession where only rewarded with a flat market. I still think fundamental analysis matters even though it has been ignored.

The chart below breaks down the earnings results versus estimates. These earnings are used to get the S&P 500 valuation in the chart above. The output gap is the difference between how much the economy is producing versus the potential for growth. QE 3 didn’t help boost the economy or earnings. It simply helped boost stock prices.

One possible explanation for the output gap is the relatively low capacity to utilization rate which is shown in the chart below. As you can see, the capacity to utilization never reached the levels seen in previous cycles. Firms are investing less and focused on buybacks more. The stock market reflects the financialization of the economy. If it represented the real economy, prices would be much lower. It’s interesting to hear justifications for why stock prices should have high multiples even though the economy is weak.

The bullish case for earnings is that Trump will cut the corporate tax rate to 15%. The effective corporate tax rate was 29% in 2016, so it’s almost being cut in half. The market clearly isn’t pricing in the tax cut as it would add about $24 to S&P 500 earnings this year. Earnings are already expected to increase from $94.55 to $117.91 without the benefits from tax cuts. If you add $24 to the $117.91 estimate and give the market an 18 multiple, you are left with a price target of 2,554 which is 6.9% higher than the current price.

Bloomberg calculated that the stock market should be valued at 4,689 if the 15% corporate tax rate is consistent for the next ten years and the market multiple is 18.5. That is a bridge too far for me because the chances of the tax rate staying consistent that long is low. The chances of passing that tax rate in the first place is also low. It’s not surprising that a scenario where the market rises 96% relies on a low probability event. The Bloomberg calculation got $1.2 billion in extra earnings by using a 15% corporate tax rate. I used the more realistic 20% tax rate which got me $791 billion in extra earnings. To be clear, this is forecasting future earnings over the next ten years and discounting them back to the present. This adds up to $92.80 in additional earnings. If you add that to the trailing twelve month earnings and use an 18 multiple, you get an S&P 500 fair value of 3,457. That still represents an increase in the stock market of 44.7%.

Obviously, the stock market hasn’t rallied either 96% or 44.7% this year. That makes sense because even if my scenario of the corporate tax rate of 20% is more realistic, the chances of it staying at that 20% rate over the next ten years aren’t that high. Trump would need to win re-election after his first term which isn’t likely given his low approval rating. It’s too early to say with any certainty whether he will win re-election, but the information we have available today suggests it will be tough for him to win.


If the corporate tax rate is cut to 20% and remains that low for the next ten years, the stock market should rally 44.7%. Those are big assumptions which is why the market hasn’t rallied that much. It’s also not certain what effective tax rate will be paid on the headline number. There will be less loopholes which means the rate that’s paid will be closer to the headline rate. The effective rate will be more consistent than what is shown in the chart above as the number of loopholes will decrease.

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