No matter which way you look at it, is very clear that Donald Trump has had a positive effect on stock markets around the world since his election as president in November 2016.
There are several possible explanations for the gains including a positive impact from reduced taxes as touted by the president, less regulation, higher economic growth and inflation driven by increased government borrowing. If any one of these factors materialized, the results would be hugely beneficial for public companies.
Still, as of yet, no actual legislation has been passed, and much of the market rally has been built on a "buy the rumor sell the news" mentality. The big question that now needs to be answered is what percentage of the recent gains will remain if Trump fails to live up to his promises?
If inflation begins to slow, economic growth doesn’t pick up, red tape remains, and taxes stay high, will the market be forgiving or will investors flock to the exits?
Buy or sell?
Ultimately, it is impossible to say with any degree of accuracy what the future has in store for markets, but Wall Street analysts are trying to put a number on the possible downside that may occur if Trump fails to live up to expectations.
Barclays has so far coined the best term for the Trump bump, noting that U.S. markets currently have a “fiscal option” in place, the option being whether Trump actually manages to push through any of his proposed changes.
Analysts have come up with three separate scenarios of how the market might react to any tax changes.
First up, the bull case which assumes a 25% corporate tax rate and a personal tax rate cut. In this scenario, analysts assume the GDP growth boosts Standard & Poor's 500 earnings per share by $3.2, and the tax rate reduction adds another $11.4 to aggregate index earnings per share. In this scenario, from the index’s already elevated levels analysts at Barclays believe the S&P 500 could charge higher by another 300 points. They assign the probability of this scenario unfolding at 50%.
Unfortunately, in any other scenario, Barclays’ equity analysts believe the index will fall. Under the Ryan tax plan and including border adjustments it’s likely there will be no benefit to S&P 500 earnings per share, a stronger dollar will prove to be a headwind against growth, and the index could fall 100 points.
In the worst-case scenario where no tax plan emerges, Barclays expects business optimism to slump and a possible 280 point decline in the S&P 500, assuming there is no long-lasting economic damage.
These figures seem to match up with what other Wall Street analysts say. It is widely believed that a failure for Trump’s tax plan would see the S&P 500 fall 5% to 10%, erasing substantially all of the gains made over the past five months. How fast, wide reaching and long the sell-off lasts for is impossible to tell.
Nonetheless, while a sell-off may be on the horizon if Trump fails to achieve his goals, trying to sell and time the market is unlikely to achieve any better results.
Learning from the past
The last comparable historical example of what Trump is trying to do with the U.S. tax code is the Reagan tax cuts in 1987. Using this example as a template, in the run-up to the introduction of the tax changes the S&P 500 rallied from 250 to 335, a gain of 34% in 10 months.
However, between the beginning of October 1987 and mid-December, the index erased all of these gains after the tax cuts were brought in and the S&P 500 dropped down to 223. Then over the next two years, the index charged back up to 360 as the tax changes were reflected in company earnings and investors profited. If the same playbook unfolds, this time around it makes sense not to sell.
The market is just doing what it has done before, buying the rumor and selling the fact. But as Benjamin Graham once said, in the long term the market is a weighing machine and no matter what the short-term fluctuations are over the long term, fundamentals will win out.
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