Goldman Sachs Explains “Rational Exuberance”

The stock market is going to rise a healthy 8% in 2018, predicts Goldman Sach’s Chief US Equity Strategist David Kostin, but the technology sector might not be the tailwind it once was. Driving the move higher will be a “rational” increase in earnings per share, driven to a degree by tax cuts, which benefit large corporations and thus help investors to a meaningful degree. But questions regarding Goldman’s forecast remain the investment bank notes in a December 8 report titled Investor response to our Rational Exuberance: 7 common questions on our 2018 outlook.

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Tax Reform Mostly Priced Into Stocks

How can analysts be so bullish with stocks at all-time high valuations?

On November 21, Kostin and his portfolio strategy research team outlined their 2018 forecast, which among other things called for price / earnings multiples to remain stable near 18 times earnings, while earnings per share is expected to grow to $150, up 14%, driving stock market appreciation.

Kostin and his team think industrials and financials will outperform as consumer stocks might be challenged while “thematically, we prefer firms that prioritize investing for growth via capex and R&D.”

Such bullish predictions don’t come without their questions from investors. Perhaps one of the most notable challenges to the bullish theme comes from the value camp, which the report pointed to as their first issue. Specifically, how can an analyst be so bullish when the S&P 500 is trading in the 99th historical valuation percentile?

“Valuations are typically poor indicators of short-term returns,” the report answers. “today’s equity valuations are justified by a macro environment of extremely low rates, modest inflation, high corporate profitability, and a stable economy.” What will drive the stock market higher, despite acknowledged high valuations, is earnings growth.

A component of the Goldman forecast is based on taking the US Federal Reserve at their word and then some. They assume four rate hikes, against the market pricing in only two hikes. What happens if they are wrong and rates don’t rise as fast? Such as “melt-up” scenario could raise P/E ratios to 19 or 20 times earnings, but Kostin and his team think such an even is “possible, but unlikely.”

What might impact stocks more than the Fed over the near term is tax reform. The extent to which this occurs, however, remains unknown.

Tax Reform Mostly Priced Into Stocks

Tax reform is driving P/E multiple expansion

Price / earnings ratios a key factor driving stock prices, and in part this expectation is reflected in a more liberal P/E ratio. If tax reform expectations were to sour, it would likewise diminish future earnings and the P/E ratios would reflect this.

Clients with whom Goldman has been talking wonder if the impact of a significant corporate tax break, moving from a top rate of 35% to near 20% is fully priced in?

Looking at both prediction markets, which reflect an 80% chance of passage, and stocks that reflect the expectations for a tax cut, measured in their own High Tax Rate basket (GSTHHTAX) stocks, thinks this eventually is, in fact, largely priced in. The devil, however, could be in the details.

“Lingering uncertainty regarding both the provisions that will be included in the final legislation as well as the potential impact of several proposals, such as limiting interest deductibility and the treatment of cross-border transactions, suggest more rotation at the industry and stock levels remains in store,” the report observed.

One component being calculated is when the tax cuts might get implemented. “The delay in rate cut until 2019 will save roughly $140 billion in government revenue but weigh on 2018 EPS as firms face several base-broadening provisions without the offsetting benefit of the rate cut,” the report noted, expecting a 5% net increase in future earnings would be unaffected.

A shining star of the 2017 stock market has been tech stocks. But in 2018, this might not be the case, leading to questions surrounding Goldman’s downgrade of the Information Technology sector despite strong sales growth and profit margins. Goldman explains the move:

The Tech sector’s low effective tax rate (19% vs. 26% for the S&P 500) means it has little to gain from tax reform. Recent performance supports our view. Regulatory risk is another reason for our downgrade. However, we recommend a Neutral weight (24%) in the sector due to strong fundamentals. Investors with sufficiently long investment horizons may find policy-driven weakness an opportunity to add to positions in the sector’s strongest secular growth constituents, which we believe remain attractive.

Ultimately growth stocks are expected to fare reasonably well in 2018 and the Senate’s proposal to limit interest detectability to 30% is likely to have no more than a negligible impact on stocks, the report predicted.

Tax Reform Mostly Priced Into Stocks