Posted by on January 15, 2017 9:21 pm
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Categories: Business Capital structure substitution theory Congress Corporate America Economy Financial ratios Fundamental analysis Investment Morgan Stanley obamacare OECD Real estate S&P S&P 500 Stock valuation Trump Administration Valuation Weekly Kickstart

Goldman is starting to get concerned.

As chief strategist David Kostin writes in his latest weekly kickstart, while stocks have surged by 6% since the election on the prospect of higher earnings under potential Trump policies, consensus bottom-up 2017 EPS forecasts for S&P 500 have been unchanged. While Goldman explains that “the surge in equity prices to investor optimism about potential policy changes under President-elect Trump; the hope is that new business-friendly legislation will increase EPS and drive shares higher” it then admits that “if new policies eventually lead to upward EPS revisions, it would be a rare occurrence. Since 1984, there have been just six years with materially positive EPS revisions: 1988, 1995, 2004-06, and 2011.

Not to make a too fine point of it, Goldman also notes that as of this moment, the S&P trades at 20.3x times its 2017 operating EPS forecast, and a vertigo-incuding 18.6x 2018 operating earnings.

Ok, but somehow the delta has to be bridged – how to make up the difference? How about lots of adjustments and addbacks, and hope that Trumpforia will lead to results. In fact, when factoring those two components alone, 2017 EPS surges from 116 to a whopping $130.

Here, Goldman has some advice to investors who are just a little concerned by this particular earnings bridge. Kostin’s advice is frankly, just as concerning:

During the quarterly reporting season that ramps up this week, we encourage investors to focus less on actual 4Q results and more on management insights on how firms are positioned on five policy issues that will drive 2017 earnings revisions and share prices. For 4Q, consensus estimates imply modestly positive results: decent sales growth will be partially offset by lower margins, resulting in adjusted EPS growth of 5% compared with last year.

So… just ignore earnings. Ok, why not. After all, Morgan Stanley had a reported titled “What, If Anything, Is Relevant About Earnings?” last week.

And yet, we – and others – are worried about the complete lack of aggregate upward 2017 EPS revisions. To Kostin this is consistent with elevated policy uncertainty, and that while Congressional leaders have outlined their agenda, details from the Trump Administration have been scant.

So, looking ahead, here is what investors should look at in terms of the five policy issues will drive the 2017 S&P 500 earnings outlook.

(1) Corporate tax rate: Our economists expect the corporate statutory tax rate will be lowered to 25%, around the OECD average but above the Trump campaign (15%) and House Republican proposals (20%). All else equal, a statutory federal rate of 25% would boost S&P 500 EPS by 8%. Stocks with the highest tax rates stand to benefit most from a lower statutory rate, and our High Tax Rate basket of stocks (GSTHHTAX) has outpaced the S&P 500 by 423 bp since Election Day. See Exhibit 5 for the constituents of this basket.

(2) Destination-based border-adjusted tax: Under this system, US firms would bear no tax burden (or a reduced tax burden) for export revenues but would no longer be able to deduct import costs when calculating their tax bases. Our economists currently assign a probability of just 30% that this proposal will be enacted. This is due in part to the potentially difficult transition to such a system, which could prove to be a significant headwind for net importers. Our apparel and retail sector analysts recently identified companies most at risk, including: NKE, VFC, RH, DLTR.

(3) Interest deductibility and depreciation policy: Changes to interest deductibility and the depreciation of capital investment appear more likely than a change to a destination-based system. However, numerous questions remain about implementation. For example, it is not yet clear whether or for how long interest payments on current debt would be grandfathered. At the index level, we estimate that an elimination or reduction of interest deductibility would partially offset the EPS benefit of a lower statutory rate. Companies with high leverage such as those in our Weak Balance Sheet basket (GSTHWBAL) would likely be adversely impacted by the change.

(4) Fiscal spending: We estimate that infrastructure spending of $25bn per year (below the $100bn per year outlined in the Trump campaign proposal) would have a modest impact on real GDP growth, increasing S&P 500 EPS by about $1. Our sector analysts expect that construction materials companies would benefit significantly from an increase in infrastructure spending. These stocks include VMC, MLM, and SUM. On the other hand, a repeal of Obamacare, an apparent priority of Congress, is likely to weigh on health care facilities. Stocks most at risk include: CYH, LPNT, HCA, and THC.

(5) Regulation: The Trump Administration will have discretion in reshaping key regulations. Much uncertainty exists, but banks and midstream energy firms are likely beneficiaries of relaxed regulations. Our Financials analysts believe MS, C, and PNC have the most EPS upside from lower regulatory costs. At the GS Energy conference last week, midstream and E&P panelists noted optimism that the regulatory environment will improve. Pipeline/MLP stocks that our sector analysts expect to outperform: EPD, MPLX, and WMB.

Divergent stock returns provide insight into what policy changes equity investors are expecting. The equity market appears to expect large health care cutbacks, but has moderated its expectations for increased fiscal stimulus. On the tax side, the equity market seems to expect meaningful corporate tax cuts, though the evidence that the market has even partially priced a switch to destination-based taxation is only mixed. Despite recent Financials and Energy outperformance and positive EPS revisions, we see little evidence that the equity market expects major financial or energy-sector deregulation that meaningfully affects profits.

* * *

With earnings season upon us, roughly 9% of S&P 500 market cap reports next week, marking the beginning of the busiest four weeks of the 4Q season (Exhibit 3). Excluding Financials, Real Estate, and Utilities, consensus expects year/year sales growth of 5% and slightly lower margins. For the aggregate S&P 500, consensus estimates imply that adjusted EPS will grow by 5% (Exhibit 4).

However, in light of the “great unknown” facing corporate America, Goldman continues to recommend “investors look past the quarterly results” and focus instead on management insights about how firms are positioned on the five policy issues discussed above that will determine  potential positive or negative earnings revisions and stock returns in 2017.

Goldman remains concerned… but optimistic. And why not if earnings no longer matter, and it’s all up to Trump.

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