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Why Tax Cuts Could Derail the Bull Market

Take note of the three headlines that hit my inbox this morning:

“Rail Breaks Intermodal Transport Records—Again”
“Boeing: Air Cargo Growth Will Double Over 20 Years”
“Analyst Says Sell Union Pacific, Genesee & Wyoming on Slowing Demand”

One of these headlines is not like the others. Why in the world would an analyst suggest selling Union Pacific (NYSE: UNP) and Genesee & Wyoming (NYSE: GWR), two of the largest railroad operators in the country, when demand is hitting record levels?

This seeming inconsistency is the trick of the stock market. It is a wild beast that demands constant fuel to keep it rocketing higher. This fuel is usually in the form of increasing growth. Note I did not say “growth” but rather, rising rates of growth.

The nuance of the sentence above may seem like a game of semantics, but it is a critical piece to understanding the puzzle of the stock market.

You see, analysts value stocks on their future earnings and the cash that might eventually flow back into the hands of shareholders. So while good news today is nice, good news tomorrow is essential.

The recent chaos in the stock market is likely correlated to a deceleration in the rate of earnings growth expected this quarter. The S&P 5f00 is down 5% over the past three weeks, just as third-quarter earnings season unfolds:

Two Major Fears

Why is the S&P 500 slumping? Investors fear third-quarter earnings growth is the top for the near-term.

According to data compiler FactSet, S&P 500 companies are expected to report an average of 19% growth in earnings this quarter. On the surface, this is a remarkable number. It is the highest rate of earnings growth since the first quarter of 2011.

But there are two issues strangling investors’ desire to be more bullish:

  • The fear that this is peak earnings growth for some time. Since September 30, the end of most companies’ fiscal third quarter, seven S&P sectors have lowered their expected growth rates.
  • The Tax Cut and Jobs Act signed by President Trump late last year gave earnings an unsustainable boost to their growth. These tax cuts represent an external event that’s unlikely to be repeated.

The massive tax cut reduced the corporate tax rate from 35% to 21%. The implications for earnings growth, which is calculated on an after-tax basis, are enormous.

Suppose a company earned $100 last year and paid 35% taxes on that amount. Its net earnings equal $65. If the company makes the same pre-tax amount of $100, its after-tax profits now equal $79 with the lower tax rate. Magically, earnings grew 21.5% without the company having to improve sales or lower expenses!

It’s quite remarkable that S&P 500 companies are, as a group, slated to enjoy just 19% earnings growth, considering the 21.5% boost promised by lower taxes. Of course, many of these multinational companies will have to pay different tax rates for their profits earned outside of the U.S. This geographic diversification dilutes the inability to pull all of the lower taxes down to their bottom line.

The jury is out on whether fourth-quarter estimates for 19% earnings growth hold up. Many high profile companies from a range of different industries cut earnings estimates dramatically for the fourth quarter and next year.

PPG Industries (NYSE: PPG), a paint maker, Textron (NYSE: TXT), which makes everything from defense equipment to snowmobiles, and United Rentals (NYSE: URI), which rents commercial building equipment, are all down between 15%-30% since cutting estimates.

Unfortunately for investors, there was not one single excuse causing these three companies to lower their rates of earnings growth. Some blamed tariffs on higher costs of the raw materials they buy, others blamed the price of oil, and some blamed lower demand due to trade uncertainty and slowing demand from China.

It might take a quarter or two for the market to sort out all these cross-currents. One thing is for sure: earnings will have a big hurdle to jump when it comes to the after-tax bounce enjoyed in the first quarter of 2018.

In the meantime, there’s a wide variety of stocks trading down in sympathy with weak peers. Some of them have operating models that insulate them from these external woes or a new product that will grow revenue regardless of global forces. The key is to pinpoint inherently strong stocks that have been unfairly punished.

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