Will tax cuts percolate through to boost economy?
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It's still early, but so far fourth-quarter earnings season is confirming what most investors had already suspected: a lower corporate tax rate is likely to boost profits and may even percolate into the broader economy.
As of Friday, 11% of S&P 500 companies had reported earnings with two thirds of them beating estimates and about a fifth coming in below expectations, according to FactSet. Analysts polled by FactSet expect earnings grew 9.5% in 2017, while revenues grew 6.2%.
But it's the guidance from companies, especially regarding the tax cut, that investors will continue to closely monitor.
"We are finally hearing from companies themselves of what they will do with the tax windfall. And so far it looks like they plan to spend about a third on wages or benefits to employees, a third on capital investments and another third on share buybacks," said Maris Ogg, president at Tower Bridge Advisors.
"This makes us believe that the tax cut is likely to have a longer-lasting positive impact on the economy because of a multiplier effect of higher wages, while companies will give back to consumers by lowering prices," Ogg said.
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Expectations of higher profits and continued economic growth is perhaps a reason behind continued rally in the stock market, with all of the main benchmarks sitting at record levels.
The S&P 500 closed at 2,810.30 on Friday, an all-time high, gaining 5% so far this year and 24% over the past 12 months. That was the 10th record close so far this month, matching the tally from January 1987 and one shy of the record for record closes set in 1964 with 11.
Once the tax cut bill was passed late last year, Wall Street analysts also ratcheted up their earnings growth expectations for 2018, according to John Butters, senior earnings analyst at FactSet.
The consensus estimate for S&P 500 earnings growth in 2018 is 18.6% which would bring earnings to $151.55 per share. Meanwhile, analysts expect 6% revenue growth in 2018.
But all of that optimism is now baked into the lofty valuations, according to Ogg.
"The expansion in valuations was justified once the tax bill was passed. But the easy money has now been made. Earnings growth needs to keep up for stocks to go higher," Ogg said.
While prices have been rising, so has volatility. Implied volatility on the S&P 500 as measured by the Cboe Volatility Index, or Vix, rose above 12 last week for the first time since November. On Friday, the Vix closed 6.8% lower at 11.38.
In the next month or two, investors will begin to focus on the outlook for earnings beyond 2018.
"What has been driving earnings growth today may turn into headwinds tomorrow, so it will be harder to get the same kind of [price-to-earnings] expansion we saw last year," Ogg said.
The price-to-earnings ratio based on the next year's estimated earnings is currently at 18.4, well above the 10-year average of 14.2 and the five-year average 15.9, according to FactSet.
The more widely used cyclically-adjusted PE ratio, or CAPE, which smooths out earnings over the previous 10 years and accounts for inflation, is currently at 33, the second-highest level after the dot-com boom in 2000.
"It is not the best time to increase exposure to U.S. equities, but high valuations are also not a reason to avoid them. At this stage we are more concerned about signs of speculation, rather than a recession," Ogg said.
Next week, 79 of the S&P 500 companies are scheduled to report results, including nine Dow components: Johnson & Johnson (JNJ), Procter & Gamble Co (PG), 3M Co.(MMM), Caterpillar Inc.(CAT), Intel Corp(INTC), General Electric Co (GE), Verizon Communications(VZ), United Technologies Corp(UTX) and Travelers Companies Inc.(TRV).
On the economic calendar, investors are likely to pay attention to existing and new home sales due on Wednesday and Thursday respectively at 10 a.m. Eastern. Durable goods orders and gross domestic product data are scheduled for Friday at 8:30 a.m. Eastern.