Trader Talk

Tax cut prospects are set to fire up earnings growth and the markets

Key Points
  • Experts are debating whether earnings have hit a peak.
  • Tax cut prospects are set to add fuel to the earnings growth story.
  • Citigroup estimates each 1 percent cut in corporate taxes will generate roughly $2 in earnings per share.
Market-watchers debate whether stocks have peaked

We haven't even started third-quarter earnings season, and already the debate focuses on what could be called peak earnings.

Is this the top for the cycle of rising earnings that began last year?

Not yet, and you can partly thank the renewed prospects for tax cuts. The markets took a leg up to historic highs late in the day Wednesday as the House Freedom Caucus endorsed the GOP tax plan.

Here's what's going on:

Earnings have been growing through 2017, after a six-quarter period in 2015 and 2016 of negative earnings. Not surprisingly, this was a period when the market traded sideways or down.

Earnings are still growing in the third quarter, but at a slightly slower rate. Overall earnings for the S&P 500 are expected to grow 6.2 percent, a bit slower than the 15.3 percent in the first quarter and 12.3 percent in the second quarter.

S&P Earnings Growth in 2017

Q117: up 15.3 percent
Q217: up 12.3 percent
Q317 (est.): up 6.2 percent
Q417 (est.): up 12.2 percent

Source: Thomson Reuters

Why the slowdown? Some of the sectors that had big moves higher are hitting tougher comparisons, principally energy and tech stocks. Energy, for example, bottomed in the second quarter of last year and had a huge boost in the second quarter of this year, so the comparisons are tougher.

Energy: Tougher Comps
(Earnings Growth)

Q2: up 563 percent
Q3: up 133 percent

Source: Thomson Reuters

Michael Nagle | Bloomberg | Getty Images

But overall earnings are still increasing and will likely stay on that path into 2018.

The economy is continuing to grow, and earnings estimates are still growing. Citigroup's chief U.S. equity strategist, Tobias Levkovich, is among many strategists who are optimistic on economic growth and believe we are not at peak earnings.

"Corporate funding costs, hiring intentions, capital spending intentions all indicate economic growth," he told me.

This year, analysts expect the S&P 500 to earn roughly $131 per share, a 10 percent increase from 2016. For 2018, earnings are expected to grow a 7 percent, to $140.

Also, tax cut prospects are again juicing the market. President Donald Trump is proposing cutting the corporate tax rate to 20 percent from 35 percent. But the effective tax rate — what corporations really pay — is about 27 percent for the S&P 500 companies, Levkovich tells me. He reckons each 1 percent cut in corporate tax generates roughly $2 in earnings per share.

Let's assume that the effective corporate rate goes down 4 percentage points to 23 percent — that would add $8 to earnings, bumping up 2018 estimates to $148 from $140.

That's a big boost — that's 6 percent more on top of the 7 percent increase that is expected without tax cuts.

That's why the market keeps holding up. The combination of expected improvement in the economy and the tax cuts indicates that we are not yet at an earnings peak.

It's no wonder the markets are so obsessed with tax cuts.