Investors are increasingly pricing in the effect of a corporate tax cut into the shares of U.S. companies, leaving the market primed for a steep selloff if the Republican-controlled Congress fails to pass one of President Donald Trump's top priorities.
The benchmark S&P 500 is up nearly 6 percent from its August lows as the Trump administration has rolled out its tax reform proposal, which would cut corporate taxes to 20 percent from the current 35 percent and allow companies to bring back some of the $2.6 trillion in cash currently held offshore at reduced rates.
Bank of America Merrill Lynch said that a positive boost from taxes "had been priced out of stocks" in July but "has been making a solid comeback."
Yet there are signs that the Trump administration has little room for error as it gets ready to introduce its tax legislation next week. The House of Representatives narrowly passed a budget measure on Thursday necessary for a vote on a tax bill, with Republicans from such high-tax states as New York and New Jersey among the opponents out of concerns that a bill would eliminate the deduction of state and local taxes.
Trump must also stem potential revolts over a proposal to scale back the level of tax-deferred contributions to 401(k) retirement savings plans, which many middle-class Americans rely on for their retirement.
"The nature of the rally over the last two months has been tax-cut led. If we don't get a cut then the market is going down" several percentage points, said Edward Perkin, chief equity investment officer at Eaton Vance.
Such a decline would be the first significant sell-off of the year, he said, but would not likely be near the 20 percent decline that signifies the start of a bear market.
A collapse in the tax measure would likely send the S&P 500 down 5 percent or more, Goldman Sachs said in an Oct. 20 note.
"Tax reform will determine the direction of the S&P 500's next 100 points," the report said.
Over the last 30 days, roughly 75 companies - ranging from delivery service United Parcel Service Inc to hotel operator Hilton Worldwide Holdings Inc - have discussed how they would benefit from a corporate tax cut on conference calls with analysts, according to a Reuters analysis of earnings call transcripts, a sign that Wall Street is increasingly focused on the tax bill.
The White House's plan would boost 2018 S&P 500 adjusted earnings per share by 12 percent, to $156, Goldman Sachs estimates, while leading to an additional $75 billion in stock buybacks.
Peter Tuz, president of Chase Investment Counsel in Charlottesville, Virginia, said that Trump's clashes over the last week with members of his own party could threaten the tax bill's success because it could alienate other Republicans. Because Republicans hold only a slim 52-48 seat advantage in the Senate, Trump can afford to lose only two votes.
"When the possibility of a defection of some Republican senators increases, that kind of puts the whole tax reform thing in jeopardy. He needs them all," Tuz said.
At the same time, the 14.4 percent year-to-date rally in the S&P 500 leaves the index primed for a decline of at least 5 percent, said Barry James, a co-portfolio manager of the $3.1 billion James Balanced Golden Rainbow fund.
The S&P 500 trades at a trailing price-to-earnings ratio of 22.6, and a forward price-to-earnings ratio of 19.5, both well above their historical norms.
"We're at levels today that are historically very risky for stocks and we're primed for a correction," James said. "If there's not the tax cut that everyone is expecting, then the correction could be a whole lot more serious."
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