Will 2018 See A Rally Based On Tax Cuts?

GOP Agrees On A Tax Plan

Senator Marco Rubio and Senator Bob Corker announced they support the latest tax plan which gives it enough votes to pass. The final vote will be on Tuesday, but at this point the decision is known. This helped the stock market rally briskly on Friday. The S&P 500 was up 0.9% and the Russell 2000 was up 1.65%. The VIX fell 10.2% to 9.42. The Dow was up 0.58%. It has been above its 100 day moving average for 401 days. That’s the 5th longest streak since 1896. The longest streak was 512 days in the mid-1950s. With the tax plan providing a strong Santa Clause rally, it makes you wonder about how much more the stock market can rally because of the tax plan in 2018. If you believe in the efficient market hypothesis, then the stock market should have already priced the tax cut in. The stronger this rally is in the next two weeks, the less bullish the JP Morgan price target of 3,000 for the S&P 500 will look. In the spring of this year, many investment banks had to alter their price targets to adjust for the momentum in the stock market. This makes you question if the analysts just say they expect a 6%-8% increase each year without basing it on rigorous research. Some notable bulls went bearish this year only to get run over by the bull. With the economy doing well and sentiment high, it’s not surprising to see all the targets optimistic.

Finishing up the discussion on the tax plan, Rubio’s vote was secured by increasing the refundable tax credit from $1,100 in the original plan to $1,400. The chart below is a sensitivity analysis on the effect of the refundable child tax credit. This increase in the tax credit is exactly what I said would happen. It makes sense that Rubio would lobby for something he thinks he can get. It wouldn’t make sense to have an unrealistic negotiating stance unless he didn’t want to vote for it in the first place. You can tell McCain was never going to vote for the healthcare plan because he said he didn’t like the entire process it was about to be passed using. I would’ve been able to forecast how that plan would have been voted on if he would have made his position clear before the vote.

Next year the Democrats will have much more power because they will have 49 Senators (if you include the Independents who are progressive). This could be good for the stock market because there will be less of a focus on Washington and more of a focus on what should be good corporate earnings. While there will be tough comparisons, mid single digit growth on top of the great growth this year is impressive.

Expensive Stocks

The Shiller PE is at 32.45. If you believe long term valuations effect long term gains, then you probably want to have a large cash position. It’s 9 basis points away from the 1929 peak. It’s easy to say that the previous decade had low returns, so this one must have high returns. That’s not a mathematical analysis. It all depends on what valuation stocks started the previous decade at. In the previous decade, stocks were the most expensive they have ever been. Some say that stocks are in a new era where multiples are high. You could’ve said the market was in a new era of low multiples in 1920. If you did, you would have missed the 2nd best rally ever. It doesn’t sound nice to say a decade of no gains destroys middle aged Americans’ ability to retire, but it’s worth noting as we approach the 9th year of this bull market.

The 6 charts below show the valuation of the stock market. The charts either go back to 1990 or 2006, so there’s not as much perspective as the Shiller PE chart I’ve shown which goes back to the 1880s. The first chart shows the trailing 12 month PE is above average, but about 8 handles below the 1990s bubble. The forward PE looks worse as it’s about 6 handles below the tech bubble and it’s above 1 standard deviation above average. The enterprise value to sales is even scarier as it’s above 1 standard deviation above the average. It’s about 50 basis points below the 1990s peak. The enterprise value to EBITDA ratio is above 1 standard deviation and near the 2007 high. The free cash flow yield isn’t much above average. It was actually higher in 2007 than the 1990s. The final chart shows the relationship between the trailing PE and the 3 year earnings compound annual growth rate. The relationship isn’t that strong, but it does show there tends to be higher earnings growth when the PE is high.

30 Risks To 2018

We are now at number 16 in the list of the 30 biggest risks to 2018. The risk is more populism because of inequality. Technically, the definition of populism is vague. There can be right wing populism or left wing populism. Based on the polls, it looks like Democrats will do well in the mid-term elections. Since Trump is still President, that means there will be gridlock which is usually good for stocks. The Mueller investigation could change that, but I don’t have any insight to add to that. This brings us to number 19 which is the Italian election. This slide is wrong. The election will be on March 15th. The latest polls show Matteo Renzi of the Democratic party has lost support. The 5 star movement has been stable which means it has taken the lead.

Conclusion

I presented 2 arguments. The first is that tax cuts will help corporate earnings enough to push stocks higher. The second is that valuations are getting closer to the 1990s bubble peak. I’m conflicted because I think stocks have had enough time to price in the tax cuts if the market is close to efficient, but based on the earnings estimates which factor in the tax cut, it might not have priced it in. If the $153 estimate is hit, the market is only at a forward PE of 17.49.

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