In 1996, during the early days of the dotcom bubble, Federal Reserve Board Chairman Alan Greenspan presciently warned of "irrational exuberance" in the stock market that eventually would lead to a crash. In a play on Greenspan's oft-quoted phrase, strategists at Goldman Sachs Group Inc. (GS) issued a report entitled "Rational Exuberance" on November 21 in which they presented an optimistic outlook for stocks in 2018, despite high current valuations.
In that report they projected a 14% increase in EPS for the S&P 500 Index (SPX), 5 percentage points of which would come from tax reform and the rest from solid economic growth. They also predicted that the S&P 500 would reach 2,850 by the end of 2018, or 7% above its open on Tuesday. Afterwards, Goldman spent two weeks discussing that 2018 outlook report with investors. Seven of the biggest questions and concerns raised in these discussions are presented in the December 8 edition of Goldman's U.S. Weekly Kickstart report, along with the firm's responses, as summarized below.
1. Aren't Valuations Too High?
While high by historical standards, Goldman believes that stock valuations today are justified by low interest rates and low inflation, as well as strong corporate earnings growth against the background of a stable economy. Their 2018 projection for further stock market gains is driven by earnings growth, rather than the expansion of valuation multiples. (For more, see also: 5 Market Predictions for 2018: Vanguard's Bogle.)
2. Can Valuations Increase?
Goldman expects the Fed to raise rates four times in 2018, as labor costs and inflation rise. They see this producing a forward P/E on the S&P 500 of 18x, and find higher multiples to be unlikely. As of December 8, the forward P/E on the S&P 500 was just under 20x, as calculated by Birinyi Associates and reported by The Wall Street Journal.
3. Why Downgrade Tech Stocks?
Tech has a lower than average effective tax rate, so tax reform will not give much of a boost. There also are risks of unfavorable regulation. However, while downgrading the sector to neutral weight, Goldman says that its "strongest secular growth constituents...remain attractive." Amazon.com Inc. (AMZN) and Google parent Alphabet Inc. (GOOGL) are the two biggest names that Goldman cites in this regard later in the report, but classifies the former as consumer discretionary, not tech.
On the other hand, Goldman recommends overweight positions in financials and industrials, based partly on their being big potential winners from tax reform, and partly on fundamental factors driving increased earnings.
4. Growth or Value in 2018?
5. Is Tax Reform Fully Priced in?
The indicators that Goldman looks at suggest that the market is giving tax reform an 80% chance of passage. However, key details still need to be ironed out, meaning that the precise impact on specific sectors and stocks remains uncertain. (For more, see also: Trump's Tax Reform Plan.)
6. What if Tax Rate Cuts Are Delayed?
The Senate proposal delays tax rate cuts until 2019. Even if that ends up in the final bill, Goldman expects "little impact on stock performance." One likely scenario, they say, is that companies will move big outlays forward into the higher tax year of 2018, providing some additional general economic stimulus, while also boosting 2019 earnings.
7. What if Interest Deductions Are Capped?
The Senate proposal to cap interest deductions at 30% of earnings before interest and taxes (EBIT) would affect only 5% of the S&P 500 companies, but 15% of the small cap companies in the Russell 2000 Index (RUT). This may become a bigger issue once interest rates rise or earnings weaken. Right now, Goldman says that the ratio of interest expense to EBIT in the S&P 500 is the lowest in at least 35 years.