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10/17/2024
Last days to price best of all possibilities: Tough decisions after the elections
David Bianco
Chief Investment Officer, Americas
Remove presidential candidates’ names and the parties controlling Congress from election scenarios and markets appear priced for outcomes that produce: 1) no Tariff hikes, 2) no tax hikes, and 3) the U.S. Federal Reserve (Fed) (Fed) quickly cutting rates to neutral in 2025. Such expected political and policy outcomes for 2025 also include a macro backdrop of: 1) healthy U.S. Gross domestic product (GDP) growth and inflation, 2) geopolitical stability, and 3) a deficit normalizing and trending to below nominal GDP growth, or the bond market just not caring about it, so 4) 10-year Treasury yields under 4%, and 5) a few years of 10% S&P earnings per share (EPS) annual growth. We imply such expectations by observing the S&P at 21.5 times our 2025 estimated EPS of $270, up 10% from 2024 estimate of $245, which assumes no corporate tax hikes. Our intrinsic valuation models support a 21.5 forward S&P price-to-earnings (P/E) ratio if S&P EPS increases 10% annually into 2027 and 10-year Treasury Inflation-Protected Securities (TIPS) yields fall to 1.5% with a 3.5% Equity risk premium (requires a confident EPS and rates outlook) for a real cost of equity of 5.0%. Thus, a fair steady-state 20 forward PE for 6% long-term S&P EPS growth.
We think tax hikes are likely in 2025 unless a Presidential veto blocks them. While we expect Republicans to take Senate by a couple of seats, we think a Harris administration can push through higher top household income and corporate tax rates by offering industrial policy benefits to red state Senators. Tax legislation is likely a first 100 days priority and needed by 2025 end given sunsets. Raising the corporate tax rate to 28% is expected to hit S&P EPS by about 7%. The amount varies by sectors/companies on geographic mix.
We remain surprised by the Fed’s unwillingness to acknowledge the structurally unsustainable deficit and the differing implications for Fiscal policy per election outcomes. If Trump wins and Treasury markets sell off, then the Fed might need to pause rest of year.
Both our and consensus S&P EPS estimates and the comparable histories of actual results are based on non Generally Accepted Accounting Principles (GAAP) figures. Non GAAP EPS is based on analysts excluding charges considered non-operating or unusual, such that exclusion better represents profitability during the short-term period being analyzed. Typical exclusions include loss on asset sales or impairments, restructuring costs, litigation costs, etc. We find non GAAP EPS measures analytically useful, but for decades we’ve cautioned that non GAAP EPS tends to overstate truly normalized earnings, historically by 5-10%. We make deductions to non GAAP EPS estimates when used in valuation models. We think GAAP EPS tends to understate normal.
Some investors argue for a sustained S&P PE well over 20 owing to higher Free Cash Flow (FCF) relative to earnings than history. It’s true that FCF is higher relative to non GAAP earnings now than history, but this requires careful consideration to correctly factor into valuation. First, the calculation of FCF vs. non Generally accepted accounting principles (GAAP) earnings must be consistent and conceptually sound. Non-GAAP EPS usually adds back all Amortization of intangibles, which can have an economic cost. And sometimes stock option expense is also added back, yet stock option issuance will reduce future FCF per share. So be careful when calculating FCF using non-GAAP net income as the stem. Second, the difference between earnings and FCF is investment. Earnings reinvestment ratios vary historically, but what matters is the return on incremental investment. The incremental return is indeed higher over the past decade than history and higher than Cost of equity (CoE) estimates. We think this continues for several more years, but we capture this in our forecasted EPS growth rates and the valuation premiums we assign to each sector above steady-state PEs for overall value-added S&P EPS growth.
We’re assessing third quarter reporting, but we’ll likely maintain our S&P EPS forecasts assuming no corporate tax changes: $245 in 2024, $270 in 2025, $300 in 2026. However, our S&P targets do not ignore the potential for tax hikes hitting our EPS estimates or affecting our 10-year Treasury yield outlook for being at 4% in a year. We will reassess after the election.
Our preference remains for Large cap and balanced style exposures. We’re not overweight small caps and question whether a rally there is sustained or runs higher on Trump. We see best risk/reward on a Trump win at large Financials, Health Care and Communications and Tech stocks. We view best reward/risk on a Harris win at Utilities, REITS, Staples.
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