Tax Cut Means Boom or Bust for Stock Market in 2018

(Bloomberg Gadfly) -- Wall Street has a lot more riding on Donald Trump's tax cuts than many realize.

Precisely how much has been a question since at least the beginning of the summer and as far back as the start of the market rally right after the election. The answer for a while seemed to be "not much." Corporate profits were rising on their own for the first time in two years, and almost no one on Wall Street had baked tax cuts into their 2017 earnings estimates. But the answer has changed as 2018 gets closer -- when tax cuts do appear to be part of the earnings math -- and as the market climbs on the Trump administration's more detailed plan. For example, Morgan Stanley's chief U.S. equity strategist, Mike Wilson, says S&P 500 companies will not be able to hit their current 2018 estimates without some sort of tax cut.

It may be more dire than that. If Trump and congressional Republicans fail to enact their tax plan, the bull market may not be able to survive, at least not without a full-blown correction. The S&P 500 Index is likely to drop 10 percent or more.

The consensus among Wall Street analysts is for S&P 500 companies to earn collectively $145.20 a share in 2018. Wilson, one of the most bullish strategists on Wall Street, says that 6 percent, or nearly $9, of that profit projection is based on a cut in the corporate tax rate to at least 25 percent. Weeden & Co.'s Mike Purves, one of the most bearish analysts on Wall Street when it comes to earnings expectations, says as much as $14 a share of next year's S&P 500 earnings is riding on a tax cut. Split the difference and you get $11.50.

Take that away for any reason, either Democratic opposition or GOP breakdown, and next year's expected earnings drop to $133.70. Based on the current estimate, the stock market is trading at 17.5 times 2018's expected earnings, which is above the historical average and already too high for many. Factor out a tax cut, though, and the S&P 500's P/E ratio rises to nearly 19. If you think it should actually be 17.5, as investors seem to, at least for now, then the S&P 500 should be trading at 2,339.75, or nearly 200 points lower than it was on Wednesday. Translate that to the Dow Jones Industrial Average, and that's a drop of 1,768 points.

But the market may actually fall more than that. Based on the current estimate, corporate profits are expected to grow a robust 12 percent next year, perhaps justifying even a P/E of 19. Without a tax cut, though, earnings will rise just 3.5 percent next year. Lower expected growth rates typically translate into lower P/E's. In early 2016, when the market's expectations for earnings growth for the next year slipped to just 5 percent, the P/E of the stock market was just under 16. Apply that, and the Dow could drop as much as 3,560 points.

Some still question whether tax cuts are truly already factored into next year's earnings estimates. But while revenue of the S&P 500 is projected to increase just 5 percent, earnings are expected to jump just more than 12 percent. With profit margins already near records, it's hard to see where an improvement would come other than from lower tax rates.

Right now the market is only treating Trump's tax talk as a boon. But if things don't go as Wall Street seems to be banking on, it could be setting up investors for a pretty big bust.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.

To contact the author of this story: Stephen Gandel in New York at sgandel2@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.