Commentary thanks to Vincent at Soren K. Group
The global stock market is just a few days from entering the history books, largely thanks to the constantly priced in tax reform. As SocGen calculates, and barring any end of year sell-off, the MSCI World index is set to record it first ever year of posting a positive total return in every single month and will hit a remarkable sequence of 14 months of positive returns.
And, as we noted in our morning wrap note, spurring the US on has been the prospect of the much promised tax cuts, with US corporation tax set to be cut to 21% from its current headline rate of 35%. Mechanically this would imply a significant boost for US EPS numbers were it not for the fact that actual tax rates are significantly lower. Top-down numbers, compiled using actual tax revenue from the BEA national accounts, suggests that the effective paid tax rate is already at 21%, and this is similar to SocGen's own bottom-up calculations using cash tax paid from report and account cash flow statements. As SocGen's Andrew Lapthorne writes in a note this morning, "Yes, tax rates from the P&L are higher, but not much higher at 25%, implying a 4% boost to net income once the reforms are passed. So positive, yes, but not dramatically so."
Which brings us back to the constant pricing in of not only tax reform but every and any form of good news. This may be a problem, because as the French bank calculated one month ago, more than all of tax reform has already been priced in, to wit:
Since Trump’s election, the S&P 500 has risen 24%. Only half of this performance has been driven by earnings growth; the other half is from P/E expansion. Assuming that analysts have not factored tax reform into their earnings forecasts, tax reform expectations have been the driver of P/E expansion. The S&P 500 index tax rate is currently 26.6%. Assuming that US companies generate 43% of their profits abroad (here) and pay 35% of their US profits on taxes (i.e. with no loopholes for US profits), the average tax rate outside the US would be 15.5%. A decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would thus theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months.
Fast forward to today with the Dow Jones more than 1,000 point higher, when SocGen again asks "so are these tax cuts priced in?" Here is the answer:
We’d argue that every bit of good news looks priced in. Median US stock valuations have rarely been higher on both a forward PE and EV/EBITDA basis and valuation dispersion remains tight in all but a few sectors. To argue for a re-rating then seems ambitious. But there has nonetheless been a clear spike in outperformance in recent weeks in stocks with higher tax rates. And perhaps this is the real story – one of rotation. But where to? Value is not cheap and suffers from balance sheet risk. Growth stocks are clear losers as they pay relatively little in tax and will have bills to settle. Perhaps it’s our old favourite, defensive orientated Quality Income stocks (that have lagged during 2017) with their Telco, Oil & Gas and Utilities bias, that will prove to be the surprising winners in 2018...
Whatever the correct answer - assuming there is one - for now stock algos don't care and take every opportunity to buy the dip, and since there are no longer any dips, just buy...
