Tax Reform Will Push Stocks To New High; Midcaps Look Ripe

Brian Jacobsen is chief portfolio strategist at Wells Fargo Funds Management. In addition to his role at Wells Fargo conducting research and giving presentations on the markets and the economy, he is an associate professor at Wisconsin Lutheran College. Jacobsen’s research and teaching center on economics, finance and investing. ETF.com recently caught up with him to get his thoughts on the economy and financial markets.

ETF.com: The last time we talked was back in October, when you told me the S&P 500 was going to hit 2,400. That was before the election, and the S&P 500 was trading around 2,150. We hit your target just a few weeks ago. Were you surprised how fast it happened, and what’s your new target for the index?

Brian Jacobsen: I wasn't surprised, because I thought that if markets got a little bit of clarity and a little bit of juice from the prospects of tax reform, that we could see a marked move higher.
The market moved so abruptly because you had the convergence of three forces. One was that global economic data had been improving since late summer/early fall, and so we had the economic momentum on our side.
Then I also thought that central banks would stay accommodative. Even though the Fed has removed some of that accommodation, it’s been very gradual in doing so. And then the third was that I figured whoever ended up winning the election would bring forward some reforms that would be favorable to the corporate bottom line.

With those three forces coming together, I thought we were poised for a marked move higher. It happened very quickly. We got to 2,400 and got a little bit of a setback. I would not be surprised if we get to 2,450 in the near term and then see a retracement that rekindles the bears' enthusiasm, because they always have to come out in order for us to make another move higher.

I also wouldn’t be surprised if some time this year we get to 2,650 on the S&P 500.

ETF.com: Do you think the failure of the health care bill jeopardizes the other important things on the Trump agenda, such as the tax cuts?

Jacobsen: The worst-case scenario is that it gets watered down, as opposed to actually getting scuttled. Tax reform has been an issue that Republicans have campaigned on for many, many years. Health care reform is something they've campaigned on just basically during the Obama administration. There's a little bit more agreement, not just among Republicans, but even among Democrats, that something needs to be done for corporate taxes.

Whether President Trump decides he's going to try to just work with Republicans or if he actually tries to work with some of the moderate Democrats with tax reform remains to be seen. But I think there are at least multiple paths forward for tax reform.

After the health care bill failure, President Trump learned he doesn't necessarily see eye to eye with the House Freedom Caucus. Thus, any tax reform that we see might be a little bit milder than the GOP plan that was released, which included the border tax adjustments and some significant changes.

What we could see is something a little bit milder, but that includes lowering the top tax rates and widening the tax base. That's something that Democrats and Republicans can both get behind.

ETF.com: How much do you see the corporate tax rate dropping?
Jacobsen: The devil's going to be in the details. My base-case scenario is to try to be conservative and assume the effective tax rate for S&P 500 companies right now is around 26%. That's because they have foreign income, which is taxed at a lower rate, and they have domestic income, which is taxed at the higher rate.
But if you suddenly see the top marginal rates in the U.S. go from 35%, say, down to 15%, well, suddenly the effective tax rate can go from 26% down to 18%. And that could be a material boost to the bottom line for S&P 500 companies. It's an even bigger boost for smaller owner and midcap companies though.

ETF.com: How much do you see corporate earnings growing by this year, and is that accounting for the tax cuts we're likely to see?

Jacobsen: Benjamin Graham, the famous investor, said that in the short run, markets are a voting machine; in the long run, they're a weighing machine. It's more about sentiment right now than the actual fundamentals of earnings for businesses.
We could see earnings grow above 8% for 2017. If you suddenly get tax reform in there, you could see earnings grow 12%. But it depends on the timing. Do the cuts hit in tax year 2017 or in tax year 2018?

I'm not sure if it matters that much if it's effective for 2017 or 2018, as long as it happens. The pendulum of sentiment is swinging between worry and relief as to whether we get tax reform done. The health care reform setback meant the pendulum was swinging toward the worry side.
Now we're going to see it swing toward the relief side. The sooner we get that done, the better. But it might not matter if it's effective for 2017, which would boost 2017 EPS, or if it's for 2018, which would then boost 2018 EPS.

ETF.com: Are there any other Trump policies you're anticipating that could be a big positive or a big negative for the stock market?

Jacobsen: If we see some of the regulatory relief, especially related to the financial services industry, that could be a positive. We've seen bank stocks move quite a bit higher since the election and a lot of that was predicated on regulatory relief, as well as a steepening of the yield curve because of monetary policy becoming a little bit less accommodative.

But right now, it's in question as to what that regulatory relief might look like. For financials in general, in order for them to really push a lot higher from here, they're going to need to see reforms with Dodd-Frank.

Jacobsen (cont'd.): Again, it's all in the timing now. Is that going to be something that they do this year? Or is it going to be next year? It was one of the reasons I was somewhat disappointed that they prioritized health care reform over tax reform and regulatory relief, because the red meat that investors wanted was with tax reform and regulatory relief.
But the red meat that voters wanted was probably healthcare reform. The politicians have to pander to their particular audience.

ETF.com: Are there any particular sectors you like in the stock market over the others? And do you like large-, mid- or small-cap stocks better?

Jacobsen: As far as the specific sectors, leaning cyclical still makes sense. I tend to favor consumer discretionary, industrials and information technology. I also like financials, because they tend to do well when the economy is doing better.

In terms of the capitalization, the sweet spot is in the midcap space. Even though valuations might not matter that much in the near term, valuations for small-caps are a little bit more stretched than what we're seeing in the midcap or in the large-cap space.
Just to build in a margin of safety, I'd much prefer to look at the midcaps. Plus when it comes to benefiting from corporate tax reform, you need to have profits to benefit from lower tax on profits. Only about two-thirds of small-cap stocks are profitable, whereas with midcaps, you get closer to 80%. So I think midcaps are perhaps in the sweet spot to benefit from any sort of move that we see on tax reform.

Contact Sumit Roy at [email protected]