The bull market in U.S. stocks is already almost nine years old and the second longest since World War II, but there are no signs it will end anytime soon.
Wall Street strategists are forecasting further gains in 2018, ranging roughly between 4% and 10% for the S&P 500, underpinned by a growing economy and strong earnings growth, with many raising their estimates for both following passage of the tax bill, which slashes corporate rates beginning next year. But even the most optimistic forecast of a 10% gain is just half the runup in the S&P 500 this year.
David Giroux, portfolio manager of the T. Rowe Price Capital Appreciation Fund, said the corporate tax cut, from 35% to 21%, could provide a onetime boost in S&P 500 earnings of 6% to 8% in 2018 on top of an already expected 5% increase. That, in turn, would reduce the price-to-earnings ratio of the index from 19 to 18 times earnings, making the index a little less pricey.
Others like Paul Eitelman at Russell Investments expect a smaller bump up in earnings due to tax cuts because many companies, especially large-caps, don’t pay rates near 35%.
None of the 11 major S&P 500 corporate sectors pay an effective tax rate above 30% except telecom (34%), according to data from Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. The tech sector has an effective rate of just under 19%, while health care is near 22% and financials and consumer discretionary sectors near 28%.
“We still have to see what kind of impact the tax cuts will have on corporate profits,” says Sam Stovall, chief investment strategist at CFRA.
That impact is expected to be a mixed bag, generally favoring companies whose profits are heavily sourced in the U.S. and taxed in the U.S., which are largely small- and mid-caps, and who carry relatively light debt loads. “While 2017 was the year of large-caps, 2018 could be the year of small-caps,” says Stovall.
But large-caps with overseas profits could benefit from a onetime 15.5% tax rate on repatriated cash in 2018. They are also likely in a better position to withstand the cut in the interest expense deduction to 30% of earnings before interest, taxes, depreciation and amortization (EBITDA) through 2021, then to 30% earnings before interest and taxes (EBIT) and the 100% expensing of capital spending.
The tax cut legislation is expected to boost U.S. economic growth by about 0.25% to 0.50% in 2018 — “it’s just too late in the business cycle to get a real boom out of this,” says Alan Levenson, chief U.S. economist at T. Rowe Price — which is a positive for stocks overall. But inflation is also expected to pick up, which could lead to a more aggressive Federal Reserve — hiking rates four times in 2018 instead of two or three — and that could stall the rally.
“Significantly higher inflation due to stronger economic growth and higher interest rates would almost undoubtedly pose a major risk to the ongoing bull run,” writes Doug Cohen, managing director of portfolio management at Athena Capital Advisors, an RIA based in Lincoln, Massachusetts, with $5.5 billion in assets.
In the meantime, market strategists will be focusing on the guidance from corporate management during the upcoming earnings season, including their plans for spending their tax cuts, as well as the usual economic indicators and the Fed’s reaction to the latest economic news. There’s little talk of recession next year, but a market correction of 5% to 10%, which is long overdue, is possible.
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