By James Mackintosh
The stock-market rally since the election is a triumph of hope over experience.
Investors hope Republican control of both Congress and the White House will mean looser regulations, lower taxes and a stronger economy, boosting corporate profits and so the value of shares. Experience should tell them that hopes of far higher earnings blossom every year, before being dashed.
This time might be different. Both President-elect Donald Trump and the Republicans in Congress have radical plans to reshape corporate taxation, and a big fiscal stimulus from tax cuts and infrastructure spending is promised.
Shareholders seem even more convinced of the potential gains than the perennially hopeful Wall Street analysts. Not only have earnings projections gone up since the election, there's also been a big jump in the valuation of every dollar of future earnings. The 12-month forward price/earnings ratio -- using Thomson Reuters IBES operating earnings -- is up to 17.2 from 16.2. That's the highest since the optimism of spring 2015, when forward PEs reached their highest in more than a decade.
Yet in 30 years of forecasts collected by IBES, only twice have S&P 500 companies delivered earnings higher than was first predicted by Wall Street. To repeat the feat would require either that forecasts are subdued, as those made in 2003 were by the memory of recession, or a late-cycle profits boom, as happened in 2006 as leverage and the subprime bubble fueled growth.
Both are possible. Earnings have gone nowhere for two years thanks to the collapse in profits in the oil and banking sectors, whose outlooks are being reassessed byanalysts. If that recovery continues -- and it can't hurt that Mr. Trump has picked Big Oil and Goldman Sachs executives for top cabinet positions -- it will underpin profits for the wider market.
Mr. Trump's stated plans could lead to a bout of economic exuberance, too. Despite near-full employment, he wants an unfunded tax cut and big infrastructure spending, the latter mostly from the private sector. In the short run, this should help the economy, boost revenues and thus bolster profits, even if focusing tax cuts on the rich achieves much less than a broader-based cut. In the longer term, of course, fiscal stimulus would raise inflationary pressures and the danger that the Federal Reserve is forced to raise rates to compensate. But that's a concern for another day.
Unfortunately for investors, it's far from clear how much stimulus will be injected into the economy or when it will come, let alone which sectors will benefit. As theFed's December minutes released this week put it, policy makers think it is "too early to know what changes in these [fiscal] policies would be implemented and how such changes might alter the economic outlook."
The rapid swing from defensive to economically sensitive stocks since the election shows investors are a lot more confident than the Fed in Mr. Trump's impact on the economy.
Still, lower corporate taxes seem a surefire way to boost earnings.
"[Calculating earnings] is a 20-variable problem, and we're all trying to isolate to one," said Adam Parker, chief U.S. equity strategist at Morgan Stanley. "But it's fair to say that the tax effect is the biggest effect [on earnings]."
He thinks lower corporate taxes could add 10% to earnings by the end of 2018, while higher revenues from stimulus add about half that.
But he warns that about half of the tax gains are likely to be passed on to consumers or offset by other tweaks to the tax code, while the stronger dollar could wipe out almost half the benefit of stimulus.
At the moment, the consensus of analysts predicts earnings growth of about 12% this year and next. That's the most optimistic they've been at the start of a year since January 2011, when earnings growth of 13% was expected for each of the next two years. Earnings growth hit that mark in 2011 but fell far short in 2012.
Perhaps this time the optimism will prove justified. The clear danger is that once Mr. Trump's plans hit congressional reality, they will be watered down or take longer to implement -- and that investors aren't prepared for such setbacks.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
January 05, 2017 12:51 ET (17:51 GMT)
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