Donald Trump's aggressive tax-cut proposal is seen as a hard sell to Congress. What's surprising is that investors don't seem to be buying the value, or possibility, of a large rate cut, either.
The White House unveiled its tax plan on Wednesday, which most notably for investors includes a huge cut in the corporate tax rate to 15 per cent from the current stated rate of 35 per cent. Investors have been eagerly awaiting the plan, and many have said renewed expectations for it is why the market has been rising recently. Nonetheless, the market slumped after the release of the plan. By the end of Wednesday, the Dow Jones Industrial Average was down about 20 points.
Buy on the rumour, sell on the news is not that extraordinary for Wall Street. What's more, the plan that the White House released, just one page, was light on details, and that could have disappointed some.
Still, the cooling of the tax-cut rally is surprising because of this: The slight drop in the market didn't signify a small skepticism about the plan, but possibly a huge one. By my math, if investors really believed Mr. Trump could get his tax plan enacted, the S&P 500 should be a lot higher. How much higher? About double.
The current corporate tax rate is 35 per cent. But that's not what companies pay because of tax breaks and the fact that at least some of those earnings come from overseas, which, at least for now, is not taxed until those dollars return to the U.S. Last year, the effective tax rate for companies in the S&P 500 that paid taxes was 29 per cent. Collectively, those companies, according to their public financial statements, which can differ from actual government payments, paid just more than $350-billion in taxes last year.
Even from 29 per cent, Mr. Trump's tax cut would be big. Bring the rate down to 15 per cent, and those S&P 500 companies would have paid $191-billion last year in taxes, boosting their income by a collective nearly $159-billion, or roughly $18 a share.
But that's just the first year. Mr. Trump is proposing to make the tax cut permanent, or at least he hasn't put a sunset on it. So that's nearly $160-billion in extra earnings a year. And those lower-taxed earnings would grow overtime. A cumulative tax benefit of nearly $1.8-trillion over the next decade. What should that be worth to investors?
Stocks in theory are worth the accumulated value of their future earnings. So discount the value of all that extra cash back to today, and you should have a pretty good estimate of how much Mr. Trump's tax plan should boost the market's value. I stuck to what the lower tax rate would generate for S&P 500 companies over the next decade, because that's usually the horizon of tax and budget planning in Washington, and then discounted that cash back to today. I grew the earnings by a conservative 2 per cent, which is about the current economic growth rate, to get to the $1.8-billion in additional earnings. And I used an 8-per-cent discount rate, the 30-year Treasury risk-free rate of 3 per cent plus an additional 5 per cent, which is conservative. The normal equity risk premium is 3 per cent, but the tax reform risk is in there, so I went a little higher.
The result: The current value of Mr. Trump's tax cut plan for the S&P 500 companies is $1.2-billion in extra earnings, or $137.85 a share. Apply an 18.5 multiple on those earnings, which is the price-to-earnings ratio that the S&P 500 is trading at for 2017 earnings estimates, and if you believe Trump's tax plan will pass, then the S&P 500 should be trading at 4,689, or 96 per cent higher than the 2,387 it closed at on Wednesday. And that factors in the nearly 250 points the S&P 500 has already risen in the Trump Bump post-election rally.
There are reasons, of course, stocks aren't soaring on Trump's tax plan. Part of it could be history. The S&P 500 rose just 14 per cent in 1986, the last time corporate tax rates were cut. Still, after 1987, stocks did really well for the next two decades. Big gains from changes in tax policy or other policies tend to be realized over time.
But Trump's proposed corporate tax rate cut is much larger than the one in 1986. And even if you believe there is only a 25-per-cent chance of the tax plan of actually passing, the S&P 500 should still be trading at 2,776, or 16 per cent higher than where it closed on Wednesday. Prediction market website PredictIt puts the chance of some corporate tax rate cut by the end of 2017 at 67 per cent, which was down from 73 per cent on Tuesday.
There are at least three possible conclusions you can draw from the large gap between where stocks are trading and where they should be valued if Mr. Trump's tax plan were to happen. One is that the stock market is very cheap. Two is that while the corporate rate cut will lower tax payments, investors don't think it will be all that great for the economy. Perhaps the added national debt will end up slowing the economy, or at the very least not produce the extra growth or jobs that Trump is predicting. The third possibility is that investors think the chance of Mr. Trump's corporate tax cut actually happening is either nil or close to it.
Whatever the answer, the bottom line is the same. Trump and his administration still have to sell his tax plan not just in Washington, but to Wall Street as well.
Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and the lead author on Time's economics blog The Curious Capitalist. His previous assignments included covering Wall Street in 1999, the housing market in 2005 and banks in 2008.