The market sees good and bad sides to tax cuts

Key Points
  • The U.S. stock market believes tax cuts will help corporate earnings.
  • With tax reform factored in, analysts believe earnings could grow 11 percent to 15 percent next year.
  • If tax cuts fall short of expectations or the Fed moves to raise interest rates too quickly, the market could be disappointed.
Pedestrians walk outside the New York Stock Exchange in the U.S.
Daniel Acker | Bloomberg | Getty Images

This could be a big day. With the Senate nearing a vote on its tax bill, corporate tax cuts are getting much more real. Aside from the global economic expansion and the record earnings this expansion is producing, the biggest marginal mover for the stock market has been tax reform.

If you doubt this, note that the moved 15 points in the hour after Sen. John McCain announced he was supporting the tax bill on Thursday.

Stocks were initially lower in Friday's premarket after the Senate announced a last-minute delay to its vote on the tax bill overnight on Thursday.

But fresh momentum was building later Friday as more GOP senators voiced their support for the bill – including Montana Senator Steve Daines and Wisconsin Senator Ron Johnson, two of the last Senate GOP holdouts.

Here is the good news: The market believes tax cuts will help earnings. The market is anticipating earnings gains of about 8 percent next year, but that is without tax reform. Models that incorporate tax reform estimate that earnings could grow 11 percent to 15 percent next year. Without tax cuts, the market forward multiple is a very pricey 18.9. With tax cuts, the multiple can be in the mid-17 level, far more reasonable.

But there is some bad news.

If you buy today, you are buying with the assumption that gains from tax cuts are happening. If you are buying today, you need a tax cut to pass, and it needs to be effective for calendar year 2018. If the rate is only, say, 25 percent rather than 20 percent, it's likely the market will be disappointed.

Even if we get the tax cuts we want, the gains will be tougher, because the market has made such explosive moves. It's getting harder to make a bull case as time goes by, even my bullish friends tell me. I don't disagree. The risk/reward is deteriorating, but the market is showing us there is more upside from tax reform. If there wasn't the market would have sold off on the McCain news.

Maybe the strategy should be to sell on the news when the tax bill is passed. That would be the immediate, knee-jerk reaction. And I wouldn't be surprised if it happened.

But I also wouldn't be surprised that, after a 5 percent to 10 percent decline, the market came back. Because now you are in 2018, and the issue is where you stand on two key issues: what U.S. and global growth will look like in the new year and how aggressive the Fed will be at raising rates.

If you are on the side that says global growth will be more than 3 percent, and that U.S. growth will be around 2.5 percent with no recession, you can certainly make an argument that stocks can continue to go up or at the very least move sideways.

If you believe that the Fed Chair nominee, Jerome Powell, will continue on Janet Yellen's path and that the Fed will raise rates in December and at most twice next year, you can also plausibly argue that the market will be able to digest those gains, assuming the economic expansion continues.

But if you think the economic expansion stalls out and is sub-par, or the Fed steps on the pedal and we get four rate hikes, you can definitely argue the markets will be lower.