We may be testing the limits of how far we can push the "tax cut" trade.
Since early last week, when momentum in Washington really picked up, sectors that would see the biggest earnings boost from tax cuts have been notable outperformers.
But there may be limits to how far investors can push this trade.
Last week, Cannacord, working with Thomson Reuters, published a study on the sectors that would get the biggest boost from a 20 percent corporate tax cut. Four of them — energy, financials, industrials and telecom — would see notable double-digit gains in earnings. One sector, technology, would see almost no boost:
Biggest gainers from 20 percent tax cut
(boost to 2018 earnings)
Energy 21.5 percent
Financials 18.5 percent
Industrials 13.2 percent
Telecom 15.5 percent
Tech 1.5 percent
Source: Cannacord/Thomson Reuters
Not surprisingly, the movement of these sectors in the past week has reflected the prospects for earnings improvement from tax cuts, and, in the case of technology, the lack of such improvement:
Sector gainers and laggards
(since last Tuesday)
Banks up 7.7 percent
Energy up 3.7 percent
Industrials up 3.6 percent
Telecom up 8.4 percent
Technology down 3.9 percent
This also helps explain the recent outperformance of so-called value stocks versus growth stocks. Value stocks (financials, energy, telecom) would simply fare better under tax cuts. Growth (technology) would not.
However, in the middle of the day, bank stocks, which have had huge gains in the past week, began selling off aggressively. Most ended the day positive, but well off their highs, on heavy volume. Other market leaders like industrials and telecom also ended off their highs.
This suggests traders are taking profits on the outsized gains, and we may be approaching the limits to the current rally.
Regardless, the tax cut is healthy because it creates a new base of stocks that can see their earnings boosted. It takes attention away from a small group of technology stocks (semiconductors, FAANG) that have received enormous attention this year.
"It ought to mean a rotation in asset allocation given that equity investors up to now have concentrated their portfolios into a small group of 'super-performers' that benefited from the disinflationary environment," said Sean Darby, chief global strategist for Jefferies.
However, we are not out of the woods yet. The Senate bill would put off corporate tax cuts until 2019, and President Donald Trump hinted over the weekend that the final corporate tax rate may not be 20 percent, but 22 percent. That will lower the expected earnings boost, and this combination could be a significant disappointment to markets.
Beyond the tax bill, traders are split between those who "sell on the news" and those who argue that any correction will be met by more buying in early 2018.
The "sell on the news" crowd has considerable support, arguing that stocks are seeing a final blowoff on the tax cut news and that it is simply unreasonable, and against the weight of history, to see stocks continue to advance.
But that's where the split occurs. Most traders believe some correction is coming, but a surprisingly large group feels that the sell-off will be met by more buying.
Tony Dwyer, chief market strategist for Cannacord, has been in the bull camp, arguing that "in our view, investors are not adjusting expectations up enough to reflect headwinds that have become tailwinds for growth."
Dwyer makes two arguments. First, he argues that the combination of global growth, a weak dollar, improving capital spending and a still-accommodative Fed will continue to help markets, though he admits some short-term correction may occur.
He also goes farther than most strategists by insisting that the S&P 500 can support a rather large multiple of 20 times forward earnings, close to where it is now.