Introducing The “Fiscal Option” Or, How To Goal Seek S&P 2,525

In terms of timing, Tuesday probably wasn’t the best day to be out setting optimistic S&P targets, but that’s how it goes sometimes when you’re kind of prodded into explaining irrational exuberance.

It’s pretty clear that no one really wants to be the guy/gal that gets “time stamped” calling for further upside in stocks right before a blow-off top, but the problem is, if you’re manning an equities desk you also don’t want to just sit around while stocks grind inexorably higher.

So you know, what ends up happening is you goal seek your way to explaining the unexplainable. Which is exactly what Barclays did yesterday by positing what the bank calls a “fiscal option” that ultimately gets the S&P to 2,525 by year-end. 

You’ll note that this comes on the heels of Credit Suisse upping their year-end target for stocks and SocGen raising their equity allocation. It’s also worth noting that it was just five weeks ago that 2,600 seemed nuts.

Here’s Barclays:

The synchronized turn up in economic data, inflation, earnings, sentiment, valuations and U.S. fiscal policy expectations has forced investors to reassess these “moving targets” and the prospect for U.S. equity returns through 2017. With the macro backdrop supportive of EPS in 2017 and valuations back to “fair” in our view, the key fulcrum for U.S. equities will be fiscal policy.We expect that for the next several months the S&P 500 will trade with an embedded fiscal “option” with the value driven by the plan size and market assessed probabilities. We target 2525 for the S&P 500 at yearend, though fiscal asymmetry is tilted to the upside.

Path will be uneven, driven by data and policy. Equities sell off at some point in every year, and 2017 will be no different with the natural oscillation of data and politics. A drawdown will come in 2017, as it always does. During the course of a year, the median peak-to-trough drawdown since WWII is 10.8%, with at least a 3-5% selloff in every year (Figure 5). Thus, the path for the U.S. equity market in 2017 will not be straight, particularly after such a strong rally and a full turn in the data cycle.

DrawdownBarcl

However, the S&P 500 has finished higher than March levels 90% of the time after a positive start to the year; solid fundamentals and a tax proposal point to further upside.

We forecast S&P 500 EPS of $129 in 2017, assuming sales growth of 5%…

BarcSales

…combined with modest margin expansion and continued repurchases leads to 8% EPS growth.

BarclEPS

Valuations have re-rated closer to “fair” and fund flows are still supportive. Adjusting for the macro drivers of multiples, the S&P trailing P/E is in line with our fitted value. U.S. equity fund inflows since the election have been just $100bn, or just 33% of 2015- 16 outflows; so fund flow support has further to run, though short covering is done.

We set an S&P 500 target of 2525 for 2017 (2450 base value + 75 for fiscal option). The “base” value assumes no fiscal impact (good or bad), 2017 estimated EPS of $129, and a trailing P/E of 19x, our current fair value adjusted for higher rates and macro vol (2450 = 129 x 19). Using three key scenarios for tax reform, we estimate a probability weighted “fiscal option” is worth 75pts. With politics so fluid, our approach allows us to assess the potential effects of policy changes as new information becomes available.

  • Upside case of 2750 (+300pts x 50% prob): 25% corporate rate, no BAT, personal tax cut. Potential upside is driven by: 1) higher GDP growth leading to ~$3.2 higher S&P EPS, 2) a 25% tax rate boosting EPS by ~$11.4, and 3) potential multiple expansion of 1x on higher LT growth expectations, real or perceived.
  • Ryan plan/BAT case (–100pts x 30% prob). EPS would not get a boost given a 6% border tax (BAT) headwind, USD strength, and a hit to growth. Higher macro vol and lower growth could reduce the P/E by about 0.8x, or -4% for the S&P 500.
  • Downside/no plan case of 2170 (-280pts x 20% prob). As business optimism and data reset lower, an admission of tax reform failure would lead to a ~9% decline as better LT growth is priced out (P/E falls 1.5x) and EPS is revised lower (-$5).

Fiscal asymmetry is still to the upside and is not fully priced. An S&P 500 upside case of +15% that does not use stretch assumptions versus a -9% downside scenario keeps us long U.S. equities. Outperformance potential of ~10% for those stocks that benefit the most from a 25% tax rate (vs. the least) also keeps us long the tax cut theme.

Target

That’s all fine and good, and I do appreciate the time that probably went into this exercise in goal seeking, but if we’ve learned anything from the first couple of months of Trump’s presidency, it’s that betting on an embedded “fiscal option” tied to tax reform and stimulus is a fool’s errand.

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