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Suddenly bullish Goldman sees a big 2018 for stocks due to 'rational exuberance'

  • With tax reform, Goldman Sachs thinks the S&P 500 will hit 2,850 in 2018, a more than 10 percent gain from current levels.
  • However, if Congress fails to act, Goldman sees the stock market index falling 5 percent.
  • The forecast favors industrials and financials and views information technology as standing to benefit least.
Tourists pose in front of the iconic Wall Street Bull near the New York Stock Exchange.
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Tourists pose in front of the iconic Wall Street Bull near the New York Stock Exchange.

The stock market is in for another strong year in 2018 so long as Congress is able to pass tax reform, according to a Goldman Sachs forecast.

With tax reform, the S&P 500 should close next year at 2,850, a healthy 10.4 percent gain from Monday's close, the Wall Street investment banking giant said in a look ahead released Tuesday. Should Congress fail to get a bill through, that outlook dims considerably, with an expected level of 2,450, which would represent a 5 percent pullback.

The prediction represents a considerably more bullish tone for Goldman, whose chief U.S. equity strategist, David Kostin, has been reserved in his expectations. In fact, the firm had predicted the S&P 500 to close 2016 at just 2,400, a mark it passed in late May and never looked back.

That brighter view also comes days after the firm's economists released their own buoyant projections for the year ahead, with expectations for greater growth both in the U.S. and globally and a domestic unemployment rate at its lowest level since 1969.

"Our 'rational exuberance' rests on a combination of above-trend US and global economic growth, low albeit slowly rising interest rates, and profit growth aided by corporate tax reform likely to be adopted by early next year," Kostin said in a report for clients.

Tax reform and profits

The bullishness stems from an expectation that tax reform will generate greater corporate profits.

Under the Republican plan making its way through Congress, the corporate tax rate will get slashed from a highest-in-the-developed-world 35 percent to 20 percent and companies will be able to bring back the $2.5 trillion they have stashed overseas at sharply lower rates.

Though critics believe it will explode the national budget deficit and by extension the $20.5 trillion national debt, Goldman also sees the plan as a cash cow for corporate America.

Under the projections, earnings will grow 14 percent in 2018 and 5 percent the following year.

That would drive the market higher in the years ahead, with the S&P 500 hitting 3,000 in 2019 and 3,100 in 2020. The latter two years represent more muted gains than the 15.3 percent so far in 2017 and the big year in 2018, which Kostin attributes to flatter margins ahead.

In terms of sector benefits, the firm upgraded industrials to overweight "as the sector benefits from solid capex trends, anticipated tax reform, and strong global economic growth." Financials also are expected to benefit from higher interest rates and less regulation.

On the downside, the firm cut information technology to neutral, with Kostin noting that the sector generates the majority of its profits from overseas and will therefore reap fewer benefits from reform than domestic companies. The sector also is up a stunning 37 percent year to date and is trading at more than 19 times earnings, making it challenging from a value standpoint.

Kostin also outlined three strategies: Secular growth, or companies where sales growth is expected to rise at least 10 percent for multiple years without high valuations; firms that are investing in capital expenditures and research and development; and companies with a strong chance to be acquired.

'Irrational' comparisons

The current market is reminiscent of the 1990s bull, he added, as stocks are benefiting from an extended economic expansion and low inflation. However, in 1996 Fed Chairman Alan Greenspan, amid a nearly 13-year bull market, issued his memorable "irrational exuberance" warning about valuations. That bull did not end until 2000.

Kostin is less concerned about the state of the present bull market that began in March 2009.

"The current equity market valuation is certainly stretched in historical terms but it does not appear unreasonable based on the high level of corporate profitability," he said. "An earnings-driven bull market is inherently rational for a fundamental equity investor."

"Irrational" will only apply if market multiples continue to expand, according to the Goldman view. If the current market would follow the 1990s bull that ended with the dot-com bubble burst, that would push the S&P 500 to 5,300 by the end of 2020, or more than double the current level, he said.

"'Rational exuberance' in our view means US stocks should continue to climb and fund managers should remain long, but preferably with a hedge in recognition that a drawdown will eventually occur along the path to a higher market level," Kostin wrote.

WATCH: Goldman strategist explains then firm's optimistic view on growth.