How Tax Reform Is Impacting Stocks and Earnings

The first six months of 2018 have been dominated by doom-and-gloom headlines. Sure, we talk about tax reform here and there, mostly around earnings season. But what kind of impact does it have on the stock market?

It has a big impact, as a matter of fact.

In the beginning of the year, stocks got off to an tremendous start. Just look at any chart that includes January of 2018. There’s one shown below, just to emphasize how out-of-control the bulls were in the beginning of the year. Was it the short-vol/long-stocks trade strategy blowing up? It might have been, as that trade finally capitulated in early February.

That was followed by the worry over rapidly rising Treasury yields. Shortly after, investors were worried about a recession as 2-year Treasury yields were spiking and 10-year yields were mostly idling, threatening to invert the yield curve. Then in March and continuing so far into June, the rhetoric has been all about escalating trade wars with China, Mexico, Canada and Europe.

But why no talk about tax reform?

Is it because that’s “so last year?” As in, tax reform was a big driver for bulls in 2017 as the White House passed extensive tax cuts for high-income earners and corporations at the end of the year? They also allowed for companies to repatriate overseas cash at a lower taxable rate.

Many may disagree on the morals of the current administration’s tax reform plans. However, it’s hard to make the case that it was bad for the stock market, which is our focus right now.

Tax Reform and Its Impact on Earnings

Tax reform is helping to fuel a big jump in bottom-line gains. Even though gross margins and revenue aren’t directly impacted by it (more on that in a minute), it makes sense why net income and margins would swell. By lowering the tax rate, corporations are able to see a larger amount of their sales trickle down to the bottom line.

As a result, this is helping to fuel earnings gains.

Tax reform was passed at the end of 2017. We’ve seen a lot of funky looking 10-Qs as a result, as companies were booking “losses” in the first quarter as they brought cash back from overseas. In reality, these tax losses weren’t actually losses, they were just large tax bills that became realized when they brought capital back from overseas.

When we back those out, Wall Street had strong growth to start the year. For instance, in the first quarter of 2018, S&P 500 companies saw 24.7% earnings growth. That’s tremendous for a supposed late-cycle economy.

Companies beat expectations at an impressive clip last quarter, as analysts proved to be far too conservative with their estimates. Will history repeat itself for second-quarter results? Wall Street is gearing up for another round of earnings beginning in July, with current expectations calling for 19% earnings growth. While that’s down quarter-over-quarter, it’s almost double what analysts were expecting just earlier this year.

Clearly tax reform is having a positive impact on earnings and that realization shouldn’t surprise anyone. Interestingly, the S&P 500’s forward P/E ratio of roughly 16.5 is only slightly above the five-year average of 16.2, despite superior growth. That would suggest that perhaps markets aren’t as overvalued as some may think.

Tax Reform and Its Impact on Stocks

Tax reform goes beyond the bottom line as well. For instance, when profits are strong, the economy is doing well and the labor market is relatively tight, how do you think consumers feel?

Generally speaking, they feel great. Economists are finally decreasing their odds of a near-term recession and everyday folks are finally getting their time in the sun too. It took a long time, but on the whole, the American worker is doing pretty darn good in 2018. That’s got top-line growth running strong, which with companies’ newly boosted net margins, only drives even more profit growth.

We’re not in a fairy tale, so this environment won’t last forever. But it’s good to enjoy it while we can. What will happen in 2019, when we lap all the year-over-year comparisons? Obviously growth will slow.

But there are other benefits to tax reform too. For instance, balance sheets for many companies should strengthen. While M&A may encourage a few big splurges — highlighted by AT&T buying Time Warner for more than $86 billion and Broadcom trying to buy Qualcomm for more than $100 billion — repatriation should allow for companies to bolster their coffers.

Companies like Apple and Warren Buffett’s Berkshire Hathaway have never had so much cash. Many are looking to stock buybacks as a way to return some of that capital to investors. Again to no surprise, when companies buyback stock, there’s less shares outstanding. It also means there is less stock to divide a company’s earnings by, thus helping to — you guessed it — drive earnings higher.

The Bottom Line on Tax Reform

So what’s the bottom line here? While we can debate whether corporate tax reform was the right thing to do, it’s the situation we’re in now. Corporate profits are seeing a boost at a time when consumer confidence is high and the economy is doing well.

While rising energy prices, interest rates and debt will hurt some, it will benefit others. Same with the trade wars. But at the end of the day, nearly all companies are benefiting from tax reform in a number of different ways and that bodes well for the stock market.

What’s the best way to play? Some may prefer individual names, but some investors should consider small cap stocks. Remember, as the dollar rallies, these mostly domestic-oriented companies don’t feel the foreign exchange-rate pinch. They also benefit from lower taxes and many have less exposure to tariffs.

tax reform boosts small caps

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