Businesses stand to get a profit windfall from the Republican tax bill, but after this year’s stock market rally, the gains won’t make their shares look cheap.
Stocks have risen sharply this year, and valuations have become increasingly stretched as a result. After climbing 19%, the S&P 500 now trades at 18.4 times expected earnings versus a forward price-earnings ratio of 16.8 at the outset of the year, according to FactSet. That is the richest it has been in 15 years. The cyclically adjusted P/E ratio popularized by economist Robert Shiller stands at 32.3, a level only exceeded just before the 1929 crash and during the dot-com bubble.
But this year’s stock market gains have been based in part on an expectation that congressional Republicans and President Donald Trump would pass a significant corporate tax cut. With House and Senate Republicans working on Friday toward a final version of the tax bill, passage looks increasingly certain.
The question now is how much of the profit windfall has already been priced into the market. In a preliminary analysis of the tax plan’s effect, based on the tax plans the House and Senate separately passed last month, Goldman Sachs strategists found that S&P 500 profits would get a 5% boost. The final tax plan doesn’t appear quite so generous—the corporate tax rate is set, for now, at 21% rather than the 20% congressional Republicans initially aimed for—but a ballpark figure of 5% still seems reasonable.
While investors have priced in at least some portion of a tax cut into stocks, analysts don’t appear to have incorporated the profit gains into their estimates for 2018 earnings. A 5% boost in earnings would lower the forward P/E ratio to 17.6, making the market slightly cheaper than it is today. (The forward P/E includes this year’s fourth quarter which will be unaffected by the tax cut.) That is still above where it was at the start of the year, when stocks were already looking expensive. Make the same 5% adjustment to Mr. Shiller’s measure, and it falls to 30.8—still lagging only the period before the 1929 crash and during the dot-com bubble.
Of course, it is possible that the tax plan boosts economic growth, which would add even more oomph to earnings than is readily apparent. As for Mr. Shiller’s measure, it may be elevated, in part, for technical reasons, making stocks appear somewhat more expensive than they actually are.
Still, stocks are finishing the year with steep valuations. The only way the market can go higher in 2018 will be if earnings surge, or if valuations go steeper still.
Write to Justin Lahart at firstname.lastname@example.org