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.
- 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
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?
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%.
Featured image courtesy of Shutterstock.
U.S. Nonfarm Payrolls Unexpectedly Decline in September
The U.S. job machine slowed significantly in September, as Hurricanes Harvey and Irma ripped through the southern states, disrupting local economies in their wake.
Overall nonfarm employment fell by 33,000 last month, following a revised gain of 169,000 in August, the Department of Labor reported from Washington. Analysts in a Bloomberg survey forecast an increase of 100,000.
The jobless rate declined to 4.2% even as workforce participation rose. That’s a level not seen since 2001.
Signs of wage inflation were present last month. Average hourly earnings rose at a faster 0.5% on month and 2.9% annually, official data showed.
Earlier this week, payrolls processor ADP Inc. said U.S. private sector employers added 135,000 positions last month. Economists had projected 98,000.
Hurricane Harvey made landfall in Texas at the end of August, triggering the biggest weekly spike in jobless claims since 2012. A total of 298,000 Americans filed for state unemployment benefits in the week ended Sept. 2, a gain of 62,000 from the week before.
September was the first negative reading on payrolls in seven years. Hiring is expected to rebound in the fall as the states of Texas and Florida resume cleanup efforts in the wake of hurricane season.
Solid employment growth has been one of the few mainstays of the U.S. economic recovery, prompting the Federal Reserve to gradually normalize monetary policy. The Fed is widely expected to raise interest rates again before year’s end. The Fed’s “great unwind” of its balance sheet will begin this month at a rate of $10 billion.
The report had no immediate impact on the currency markets, with the U.S. dollar index (DXY) rising gradually shortly after the data were announced.
«Featured image from Shutterstock.»
BOJ Rate Decision: Bank of Japan Keeps Policy on Hold After September Meeting
The Bank of Japan (BOJ) has voted to keep its trend-setting interest rate at record lows, as policymakers continue to rely on record stimulus to keep the economy humming.
BOJ Policy Decision
In an 8-1 vote, the BOJ kept its benchmark interest rate at -0.1%, where it has stood since January 2016. The decision was widely expected by economists, who say the BOJ is unlikely to budge on monetary policy anytime soon.
The BOJ also maintained its purchase of Japanese government bonds (JGBs) so that the 10-year JGB yield remains at zero percent. Meanwhile, annual bond purchases continue to be held at ¥80 trillion.
The BOJ shifted course on monetary policy last September when it made yield-curve targeting its central concern. Since then, it has been status quo.
Economic Picture Brightens
Central bankers have been largely hands-off to let monetary policy do its job. Recent data suggest ultra-loose policies are finally having their desired effect. Japan is currently in the midst of its longest period of uninterrupted growth in more than a decade. Quarterly gross domestic product (GDP) expanded 0.6% between March and June, the fastest in more than two years.
In annualized terms, the economy expanded 4% in the second quarter, official data showed. That was much bigger than the 2.5% annualized gain forecast by economists.
Japan has now been on the right side of growth for six consecutive quarters and nine of the past 11.
Strong domestic demand and a synchronized global recovery lifting Japanese exports have been the main factors behind the growth.
Despite solid growth, inflation continues to lag the central bank target of 2%. Core inflation rose in July for the seventh straight month, but came in at just 0.5%. National CPI also expanded 0.5% annually in July for its seventh straight gain.
Inflation has been so disappointing that the BOJ recently postponed its inflation deadline for the sixth straight time. The move highlights the growing frustration with low inflation under the Abe regime.
Yen Losing Ground
Japan’s currency declined again on Thursday to trade at fresh two-month lows. The dollar-yen (USD/JPY) exchange rate reached a session high of 112.65 before paring gains. At the time of writing, the pair is up 0.2% at 112.51.
The yen has been in free-fall for the past two weeks as risk sentiment returned to the financial markets. The yen is a highly liquid reserve currency that usually receives strong bids during periods of instability. With investors pouring money into stocks, the yen has fallen by the wayside in recent weeks.
Breaking News: Dollar Soars as Fed Reveals Tapering Plan
Highlights of the Fed Meeting
- The Fed will start reducing its balance sheet next month
- No interest rate change this time around, benchmark rate remains at 1.25%
- December hike much more likely than previously
- No change in outlook language
Overall our expectations of a slightly hawkish Fed were fulfilled, as the immediate start of the tapering is quicker than expected, and 11 was the number of Fed officials that see another rate hike in 2017, with only for expecting the rate to remain 1.25%. The market is pricing in a 50% chance for a hike and the ratio suggests that the majority of the Fed officials are leaning towards another tightening step. We expect the Fed to closely monitor the reaction of the market and intervene verbally should risk assets react in an “unwanted” way.
EUR/USD, Hourly Chart
What’s Next for the Markets?
The Dollar is rallying heavily after the hawkish announcement and the with the significant devaluation of the currency in recent months, there is ample room for a bounce to form. The currency pair has a strong support zone near 1.17 that could serve as a primary target for the move.
Stock markets are tumbling int he wake of the decision but given the recent strength in equities, in the face of the rising interest rate expectations, we don’t expect a serious move lower after the decision, despite the valuation concerns. Financial stocks should outperform, on the rising rate expectations, while tech issues and growth stocks should lag the broader indices. The major indices are around 0.5% lower since the decision, but even the short-term uptrends aren’t in danger for now.
S&P 500, Hourly Chart
Bitcoin got slightly lower following the announcement, but the decline is minuscule compared to the recent moves in the coin and it seems unlikely that it will have a meaningful effect on the cryptocurrency segment, despite the theoretically bearish implication. Gold will likely be pushed lower in its correction, but the long-term uptrend should remain intact.
Featured image from Shutterstock
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