Tax reform has gone from a market dream to a near reality, and investors are positioning themselves for the road ahead.
Banks, media and transports were the big winners Monday, the first day after the Senate approved its version of the Republican-sponsored plan. Tech stocks took a beating in what could be an ominous sign for the sector, while health care and utilities also fared poorly as investors demonstrated a preference for cyclicals over defensive.
What is in store longer term for the market, though, is cloudier. Multiple factors will come into play, from effective tax rate calculations to consumer impact to how companies will put to use the expected windfall they'll receive from a sharp reduction in their currently highest-in-the-world nominal rates.
"Even after the President signs tax reform into law, company-level implications will remain unclear for quite some time," Jonathan Golub, chief U.S. equity strategist at Credit Suisse, told clients. "The full impact of the new tax code is impossible to calculate given yet unknown behavioral changes."
Still, Wall Street strategists will try to gauge the effects, and had their pencils out again Monday looking to discern where the biggest impacts will fall.
Starting from the top
On the surface, it's only logical to figure that sectors with the highest effective tax rate — what they pay after deductions — would stand to gain the most at least on proportion.
That would put retailers, telecom, industrial services, utilities, retail staples, and health-care equipment and services at the front of the line, as each has an effective rate above 30 percent, according to Credit Suisse.
On the opposite side, real estate investment trusts, energy, autos, pharma and biotech, semiconductors, and software and services would benefit the least, as those sectors have effective rates under 20 percent.
On the overall, companies in the pay a 26.2 percent effective rate, compared with the 35 percent top nominal rate in place now and the 20 percent where the reform bill would go.
But Golub said there are other things to consider, including how companies would use the savings — whether it would go to growth measures like capital expenditures and acquisitions or to shareholder benefits like dividends and buybacks.
Homegrown help
With the reform plan aimed at spurring activity domestically, companies that do more business in the U.S. should be prime beneficiaries.
That's why Morgan Stanley likes small- and mid-cap stocks as a reform play, and is growing wary of the high-flying tech sector that has led the market so far in 2017.
"Part of our call on the cycle has been our call on SMID cap stocks, which we believed would be relatively large beneficiaries of tax reform, deregulation, and animal spirits as domestic activity and M&A picked back up," equity strategist Michael Wilson said. "As sentiment has grown around tax reform since the late summer, this trend has been playing out but we think it has further to go."
While the firm still has an overweight rating on technology, Wilson said the latest sell-off could be "a cautionary note about what may eventually unfold in the sector as the market starts to price in a tired cycle over the course of 2018." He suggested investors may want to buy tax reform winners by selling this year's tech proceeds.
The trend could be played out by funds that hold high concentrations in tech. Hedge funds are 40 percent weighed in a sector that David Kostin, chief U.S. equity strategist at Goldman Sachs, said would receive "limited relative benefits from tax reform, elevated valuations, and risk of government regulation."
One other area that could benefit, though: aerospace and defense.
Analysts at Baird said the average tax rate for the industry is 28 percent and the sector generates about three-quarters of its revenue domestically.
Among the stocks that Baird likes are BWX Technologies, Mercury Systems and Spirit AeroSystems Holdings.
WATCH: A look inside the tax reform rally.
