Stocks have cleared two of three major hurdles in the past day. The last may be the most difficult of all.
The outcome of both the Dutch election and the Federal Reserve meeting were market friendly. The Dutch appear to have turned back a populist tide, and the Fed has calmed rate hike jitters by clearly implying rate hikes would continue to be gradual, which means three hikes this year, three hikes next.
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This is a remarkable feat: the market has convinced itself that it can keep going even though the Fed is changing its stance from being "data-dependent" to "we're going to keep raising rates for a while."
But that's only happening because of the last hurdle: the Trump rally, the magic elixir of tax cuts, lower regulations, and infrastructure spending that is not the sole reason for the market rising, but arguably has been the primary reason.
How long will the market continue to give the "Trump rally" the benefit of the doubt? For the moment, the market's support has been unwavering.
A more interesting debate has emerged this week: has the market already discounted the full effect of Trump's proposed tax cuts, infrastructure spending, and reduction in regulations, and won't rally much more even if the agenda is passed?
It's a good question, and I think the answer is: there is plenty of upside. It's one thing for the market to move on vague hopes of tax cuts and less regulation — I agree it's a big part of the recent boost — but it's another when you actually see real numbers. And that's when we can get a second boost.
Let me show what I'm talking about. There have been numerous studies done on the potential impact of tax cuts. One done by Thomson Reuters noted that while the stated corporate tax rate is 35 percent, the effective tax-rate — what the average company actually pays — is 26 percent. They estimated that changing the effective tax rate from 26 percent to 20 percent would increase earnings in the S&P 500 by 8.7 percent.
That is a huge increase. Bear in mind that we have just come off an earnings recession, where earnings decreased for five quarters before finally rebounding.
The market has rallied on these kinds of expectations, but don't kid yourself: no company has changed guidance, and few if analysts are boosting their numbers this year, based on this. Not yet.
And that's why there is still plenty of room for upside. Once these pass, the guidance increase will give a new boost to stocks.
JP Morgan quant strategist Marko Kolanovic, who is widely followed on Wall Street, noted as much in a note to clients today, claiming that the Trump Agenda amounts to a "Trump put": "[A]ssuming the full benefit of tax reform on 2018 earnings ... would justify the S&P 500 at meaningfully higher level than our current price target of 2,400."
The downside is that if we get a smaller loaf than expected — particularly a much more modest tax cut — the market will adjust downward.