S&P 500 tax reform

Goldman Answers 7 Questions About Their 2018 U.S. Equity Outlook

"How can you be “rationally exuberant” about the path of US stocks in 2018 when equity valuations are so high?"

As you know, Goldman recently released their 2018 year-ahead outlook for U.S. stocks.

The piece, called “rational exuberance”, is generally consistent with everyone else’s year-ahead outlook pieces for risk assets (Barclays was actually first with the “rational exuberance” title), but this being Goldman, it got the most attention.

Of course there’s something not quite right about the term “rational exuberance.” “Exuberance” implies at least a little bit of irrationality in most cases and there is most assuredly some irrationality inherent in being “exuberant” about an asset class that is stretched to historical extremes on all kinds of standard metrics.

But here’s the thing: assuming the ubiquitous “Goldilocks” narrative of decent global growth but still subdued inflation continues to be a reasonably accurate description of economic reality and assuming subdued inflation gives central banks the cover they need to keep the pace of normalization sufficiently gradual, there’s a plausible argument to be made that risk assets have further to run.

That, plus a rosy outlook for earnings growth, is the basis for the Street’s generally upbeat take on U.S. stocks headed into the new year. You can read more of the details on Goldman’s outlook in the first post linked above, but suffice to say these are their targets:

Our S&P 500 year-end forecasts are 2850 (2018), 3000 (2019), and 3100 (2020) for gains of 11%, 5%, and 3%.

That hinges on three things:

  1. above-trend US and global economic growth
  2. low albeit slowly rising interest rates
  3. profit growth aided by corporate tax reform likely to be adopted by early next year

And if you want to know how this is “rational” exuberance as opposed to the infamous “irrational exuberance”, Goldman is happy to explain it to you but this chart sums it up (the idea is that the market doesn’t need rampant multiple expansion to hit the bank’s targets and thus the trajectory will not approximate the lead up to the tech bubble):


Ok, so against that backdrop, Goldman is out with a new piece that documents “seven common questions” clients are asking about their outlook. Here they are, along with some excerpts from the bank’s answers:

  1. How can you be “rationally exuberant” about the path of US stocks in 2018 when equity valuations are so high? In contrast to the “irrationally exuberant” market of the late 1990s, today’s equity valuations are justified by a macro environment of extremely low rates, modest inflation, high corporate profitability, and a stable economy. Nonetheless, earnings growth, rather than higher valuation, drives our 2018 forecast.
  2. If the out-of-consensus US Economics forecast for the Treasury yield curve is wrong and rates stay low in 2018, could equity valuations rise further? The “melt-up” scenario of a forward P/E that rises to 19x or 20x is possible, but unlikely. A rising term premium should lift the 10- year Treasury yield to 3.0% and restrain further P/E multiple expansion.
  3. Why did you downgrade the Information Technology sector when it has twice the sales growth and twice the margins of the rest of the S&P 500? The Tech sector’s low effective tax rate (19% vs. 26% for the S&P 500) means it has little to gain from tax reform. Recent performance supports our view. Regulatory risk is another reason for our downgrade.
  4. Following value stock outperformance during recent weeks, do you still recommend growth as a style in 2018? Concentrated positioning and correlation with the Technology sector are clearly short-term headwinds to growth stocks. However, our economists’ forecast of 2.5% US GDP growth in 2018 portrays an economic environment typically conducive to growth stock outperformance and suggests that our sectorneutral growth factor should fare well during the course of the year.
  5. Is the equity market already pricing the full impact of tax reform? Lingering uncertainty regarding both the provisions that will be included in the final legislation as well as the potential impact of several proposals, such as limiting interest deductibility and the treatment of cross-border transactions, suggest more rotation at the industry and stock levels remains in store.


6. What does the Senate proposal to delay the tax rate cut until 2019 mean for S&P 500 earnings and performance? The delay in rate cut until 2019 will save roughly $140 billion in government revenue but weigh on 2018 EPS as firms face several base-broadening provisions without the offsetting benefit of the rate cut [but] we expect little impact on stock performance from a potential delay in tax cut.

7. How big a risk to EPS is the Senate’s proposal to limit interest deductibility at 30% of EBIT? The proposal would have a minor impact on S&P 500 firms but pose a greater risk to more highly-levered small-caps.


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