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Tax cut could spark a reckless rush into the stock market

  • The markets might get a test of how much of a good thing is too much.
  • The more the tax cut windfall flows to the bottom line and bolsters shareholder value, the less is spent directly on growth-and-job-boosting initiatives.
  • "Rational recklessness" means taking advantage of tax inducements to put capital at risk even without high confidence in the ultimate payoff.

Boosters of the new corporate tax cut are effectively promising it will spark a rush of "rational recklessness."

That's not how Republicans in Congress and economists who favor the new law might put it. They argue the new 21 percent corporate rate and ability to deduct the full cost of new capital investment immediately will make American companies more competitive and unlock pent-up demand for corporate investment.

But the idea of cutting taxes on capital, allowing more investment income to flow to asset owners and creating strong incentives for companies to spend heavily on plant and equipment eight years into an economic expansion implies a hope that businesses and investors will bet heavily on a stronger, longer economic cycle when they otherwise might be bracing for a slowdown.

In the process, the markets might get a test of how much of a good thing is too much. Perhaps this will be the subject of the next chapter of this bull market, which has passed through several dominant story lines since stock prices bottomed nearly nine years ago.

Wall Street strategists reacted to the tax vote by quickly bumping up forecasts of 2018 earnings for S&P 500 companies. This is actually quite an imperfect science, but undoubtedly a net positive to reported profits.

Tony Dwyer of Canaccord Genuity, making a blanket assumption that all sectors will have a 21 percent effective rate, pencils in an 8.8 percent boost to his 2018 estimates, to a whopping $155 – all told, a 17 percent rise in earnings over expected 2017 results. Dwyer plugs in a 20 price-to-earnings multiple to arrive at an S&P 500 price target of 3,100 for next year, up more than 15 percent from current levels.

Tobias Levkovich at Citi is somewhat more conservative, lifting his 2018 earnings projection to $146 from $141. He says, "Each 1% of tax rate decline theoretically adds nearly $2 of EPS but several company management teams are suggesting that a portion of the tax savings will be used for competitive strategies, which may include price cuts and/or more marketing expenditures. Thus, it may be presumptuous to build the full benefit into 2018's projections and Street hopes of a very large boost may be disappointed."

His 2018 S&P target is just 2,800, allowing for some compression of the P/E because tax cut-driven profit growth is nonrecurring and likely won't command the same valuation as operating earnings.

These differing views illustrate some of the possible offsets. While it's not strictly a zero-sum equation, the more the tax cut windfall flows to the bottom line and bolsters shareholder value, the less is spent directly on growth-and-job-boosting initiatives.

But what if it works for the economy roughly as promised by the tax cut optimists? We'd be pushing corporate leaders to plow fresh money into vehicles, robots, buildings and factories with the economy already growing at what many economists view as an "above-trend" pace. The incentives theoretically drop the break-even threshold for new investment.

But implicitly, this means that executives who did not see attractive returns on capital for a full eight years of an expansion amid historically low interest rates will now add capacity aggressively — just as labor markets have grown tighter, wages are nudging higher and pricing power remains elusive.

This would represent "rational recklessness" — taking advantage of tax inducements to put capital at risk even without high confidence in the ultimate payoff. Is this truly the ideal time for companies to set aside capital discipline? Will investors look kindly on companies handing out employee bonuses and ramping up capital spending? And the largest beneficiaries of the tax cuts are the Old Economy, domestic, more cyclical companies, which tend to trade at lower multiples — so how much help will this be to the market in aggregate?

Of course, "rational recklessness" could also be called "animal spirits." Such spirits are a feature of all bull markets, and clearly they've begun animating investors and CEOs over the past several months.

One can certainly argue that the economy and markets can be carried along by this virtuous cycle for a while before the good news curdles into higher interest rates or inflation or fears of overheating or signs of uneconomic over-investment.

Under this potential bullish 2018 story line, "lower for longer" (referring to interest rates and growth pace) gives way to "stronger for now": Sure, stocks are expensive and investors at every level are finishing 2017 with heavy exposure to stocks. But global growth, easy financial conditions and the tax cuts can prolong the cycle and kick it into a somewhat higher gear.

This bull market emerged from the crucible of the financial crisis in early 2009, when the most plausible bullish argument was "stocks are just too depressed at 12-year lows and the economy will eventually recover." Then came, "the economy is slowly healing" and "don't fight the Fed," and on to "equities are still attractive vs. bonds" to "the market's pricey but deregulation and tax cuts are coming."

All along the way, these narratives had a grain of truth but lacked full explanatory power. Markets trend higher for years at a time and rarely fail in a dramatic way absent a recession. Stocks roughly track earnings with huge swing factors tied to crowd sentiment and credit conditions. Sentiment right now seems a bit stretched, the S&P 500 is "overbought" to a historic degree, we're overdue for a 5 percent gut check and the tax bill creates brand-new winners and losers.

But the market's behavior itself has given few indications that a major peak is near at hand, and the "rational recklessness" and "party until the music stops" plot threads are perfectly plausible excuses for good times to carry on into 2018.