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U.S. stocks are overvalued unless the government can get tax reform done, Goldman Sachs' David Kostin said.
"While we expect the modest rebound in [return on equity] will continue in 2017, a substantial increase in profitability in 2018 will likely require policy tailwinds, " Kostin, the bank's chief U.S. equity strategist, said in a note to clients Friday. Return on equity is a measure of how profitable a stock or an index is.
Stocks have had a banner year thus far. The S&P 500 is up 14.3 percent in 2017 in part because of strong corporate earnings growth, solid economic fundamentals and hopes for tax reform.
But Kostin noted that the S&P 500 is currently trading in the 88th percentile of historical valuations "on a variety of metrics," including price-to-book. He expects a "modest contraction" in the index's valuation multiples given their already high levels and expected tightening from the Federal Reserve.
If multiples contract, fundamental factors such as earnings and book value have to improve to drive the index price higher.
The central bank expects the benchmark rate to be 2.1 percent by the end of 2018, according to the latest projections released Sept. 20. The benchmark rate currently sits in a range of 1 percent to 1.25 percent.
However, these headwinds "would be trumped" by a cut in the corporate tax rate, Kostin said.
"The current White House tax reform proposal would reduce the federal statutory corporate tax rate to 20%. Based on the current effective tax rate, the proposed change would lift S&P 500 ROE by roughly 100bp [basis points]. If the federal statutory corporate tax rate instead moved to 25%, S&P 500 ROE would increase by roughly 50 bp," he said.
Kostin added energy and utilities could be the two sectors that benefit the most from lower taxes. He notes they have the highest 10-year median effective tax rates for S&P 500 sectors.
"The final impact of a tax cut could change, however, depending on other provisions included in the final legislation, such as the treatment of interest deductibility."