Yesterday we laid out the reasons why French bank SocGen unveiled a surprisingly contrarian forecast, according to which the S&P would tumble from its current level over 2,600 to 2,000 in 2018, representing a more than 20% bear market drop…
… the drop catalyzed by rising interest rates pressuring P/E multiples, a late cycle economy nearing recession, equities trading at record valuations, and with everyone short vol begging for a vol short squeeze. Not surprisingly, SocGen’s unspoken advice was to get out now.
And while many of the negative factors highlighted by SocGen had already been discussed here in the past, there were two we warned to bring attention to: the market’s multiple expansion since Trump’s election, and the narrow leadership in the S&P.
As we noted yesterday, contrary to the widely accepted narrative, while the S&P 500 has risen 24% since Trump’s election, only half of this performance has been driven by earnings growth; the other half is from P/E expansion. But why would P/Es rise at a time when the Fed is tightening? As SocGen speculated, assuming that analysts have not factored tax reform into their earnings forecasts, tax reform expectations have been the driver of P/E expansion. There is a problem with this: while the S&P 500 index tax rate is currently 26.6%, assuming that US companies generate 43% of their profits abroad (here) and pay 35% of their US profits on taxes (i.e. with no loopholes for US profits), the average tax rate outside the US would be 15.5%. A decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would thus theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months. In other words, roughly 150% of Trump’s tax cuts have been priced in!
However, another especially interesting observations goes to the leadership of this 24% rally since Trump’s election, which – while hardly a surprise – was largely driven by a handfull of companies, or ten to be precise.
As SocGen calculates, just 10 contributors of the S&P 500’s bull run have accounted for 33% of the S&P 500 performance. Tying to the above, the bank also points out that all of the companies listed below have seen their P/Es expand over the last 12 months, in some cases – like Nvidia, WalMart, Boeing and Amazon – dramatically. In fact, only three companies (Apple and the two banks) have 12-month P/Es that are below the market average (18x). Lastly, keep in mind that except Amazon, all of the companies already pay a corporate tax rate below the current US federal tax rate (35%), and five companies even pay a tax rate that is below the 20% rate targeted by Trump’s tax reform.
As we asked two days ago when we showed that the bulk of hedge funds gains in 2017 have come from holding this same handful of companies, what happens to hedge fund performance – and the S&P 500 – when, for whatever reason, the tide turns and the winners are the first to be sold?