If you followed the “experts” over the past few months, you may have missed a major rally.
Much of the mainstream media predicted the election of Donald Trump as U.S. president would wreak havoc on the market.
Just take a look at what the Cassandras over at The Atlantic had to say about Trump’s victory back in October 2016:
For a year and a half, Trump’s core claim to presidential competence has been his business record. But his campaign has been disastrous for his business and nightmare-inducing for the global investor community. Count it as one of the last historic accomplishments of a truly historic campaign: Trump is so frightening he’s turned the global financial markets against a tax-cutting billionaire.
Not to be outdone, the doomsayers over at Fast Company made this gloomy prediction in November 2016:
If Trump were able to implement the economic policies that he wants—from tax cuts for the rich to booting out undocumented workers and adding tariffs on Chinese products—the economy would sink back into a recession.
Even top Republican donor Paul Singer got in on the act, proclaiming a Trump presidency would trigger a “widespread global depression.”
But the exact opposite happened.
The large-cap S&P 500 is up almost 9% since November 4. And the small-cap Russell 2000 is up a staggering 19%. Check out the chart below…
The crazy thing is these moves happened in just over one month. In fact, it’s the biggest monthly return for the Russell 2000 since the Greek debt crisis in 2011.
What’s Behind the “Trump Rally”?
It comes down to how investors value securities.
Trump campaigned on a promise to make America business-friendly again. He pledged to reduce regulations, cut red tape… and, most importantly, cut taxes.
He wants to cut the corporate tax rate from 35% to 15%. And that’s good news for stocks.
The market is forward-looking… That means investors derive stock values based on future expectations. If investors expect a company to earn more profits in the future, it will be worth more today.
There are several metrics investors use to value stocks. The most common is the price-to-earnings (P/E) ratio. It measures how much investors are willing to pay for each dollar of profit a company currently earns.
Let me show you how this Trump “effect” worked. We’ll use mega-retailer Target (TGT) as an example.
The day before the election, TGT closed around $67. Over the past year, TGT earned $5.63 per share. To get its P/E ratio, you’d divide the share price by the earnings per share (EPS). That works out to about $12 (67 divided by 5.63).
That means investors are willing to pay $12 for each dollar of profit Target makes.
Now, here’s why Trump’s pledge to cut corporate taxes has been positive for stocks…
Last year, Target paid 32% in corporate taxes. Before taxes, the company earned $8.28 per share. After taxes, it was $5.63.
If Trump gets his way, corporations will only pay a 15% tax. At that rate, Target’s after-tax EPS would increase to $7.04.
Assuming investors are still willing to pay $12 for each dollar in current Target profits, TGT shares would be revalued at $84.50 (12 times 7.04). That’s a 26% gain.
Target wouldn’t be the only company to benefit from a potential tax cut. Entire sectors would get a boost. And that’s why the stock market is rallying.
Three Sectors to Watch
The market is looking forward to Trump’s promised tax cuts. If companies can keep more money because of lower taxes, their profits will grow… And investors will bid up the price for their shares.
Now, not all stocks will be treated equally, though.
Companies that pay little or no taxes won’t see major adjustments due to lower corporate tax rates. The biggest market winners during a Trump presidency will likely be companies that are taxed the most.
According to Citizens for Tax Justice, the three most taxed industries are retail, healthcare, and publishing. Watch these sectors if the talks of tax cuts get serious.
Nick Rokke, CFA
Analyst, The Palm Beach Daily
The sector with the highest effective tax rate is retail.
As you can see in the chart below, it’s already moved up significantly after the election. But if the tax cuts get passed, the sector will go even higher.
All else equal, a new corporate tax rate could push up the retail sector another 10%. And that’s just the average company. If you dig deeper, you can find companies that will benefit even more.