I've seen Wall Street analysts make some bad calls before, but this one really takes the cake. They're so far off base that even a major Wall Street firm is calling them out for being behind the curve.
In a note to clients, Credit Suisse said the following:
"Analysts have adjusted their 2018 forecasts by less than 2% for recent tax changes, a fraction of the likely impact."
MUST-SEE: Controversial Open Letter To President Trump
In other words, Wall Street’s best and brightest are massively underestimating how much the new tax law will benefit companies' bottom lines. Anyone investing based on those analysts' current predictions will be in for big surprises as we move through 2018 -- possibly in as little as a few weeks.
How will this affect markets -- and how can you profit from this oversight?
That's exactly what we're going to cover in today's alert.
Corporate Tax Cuts and Earnings Implications
As you well know, a new tax bill was signed into law just before Christmas, cutting corporate taxes from a high of 35% to a top rate of just 21%.
This tax cut is a major win for investors, because it means corporations will pay less in taxes, leaving more earnings on the table.
How much will this tax cut add to earnings?
Well I ran through the numbers and created a table to show you just how much more profit companies will be able to keep.
Follow along with me as we look at the difference between 2017 profits and what will happen in 2018.
Let’s assume we're considering investing in shares of a company that makes pre-tax income of $5.00 per share.
In 2017, that company would have its pre-tax profits taxed at 35%. So after paying taxes, investors would be left with earnings per share of $3.25. For most responsible investors, earnings per share is the number one metric for determining a fair stock price.
Now fast forward to 2018...
Thanks to the new tax law, this same company will only have to pay 21% tax. This leaves our stock with $3.95 in earnings per share, good for a 21.5% increase over last year's profits.
Keep in mind, this projection doesn't include any growth the underlying business may have in 2018. Earnings for this stock will jump by 21.5% simply because the company is paying less in taxes.
For just about any stock, a 21.5% annual jump in earnings is a very attractive increase!
Wall Street Is Behind the Curve
That's why it is so surprising that most Wall Street analysts have yet to adjust their earnings models for lower taxes.
Sure, some companies were already taking advantage of loopholes to reduce their taxes in 2017. So the net result may be muted a bit.
But even so, the benefit of lower tax rates will certainly have much more than a 2% increase in corporate earnings.
The corporate tax cuts is one of the reasons I'm still bullish on the stock market.
Yes, the market has been running higher for nearly a decade now. And yes, there are some areas of the market that I am concerned about.
But the majority of stocks -- and the market in general -- should still have plenty of room to run thanks to a 21.5% increase in earnings that is basically built in by the corporate tax cut.
This year, Wall Street analysts haven't properly built in the effects of the tax cuts.
Maybe it's because of their liberal bias. Maybe they don't want to admit that these tax cuts will be good for the U.S. economy.
Whatever the case, companies are likely to surprise these analysts (and the investors who follow them) when earnings are reported higher than expected.
The effects could begin as early as this week!
That's because earnings season is kicking off this week and companies typically issue guidance for the year ahead when reporting fourth quarter earnings.
I expect guidance to be higher than analysts are currently projecting. And positive company guidance will lead to more investor excitement. Of course that means more buying and higher stock prices.
Small Caps Should Take the Cake
So what areas of the markets should benefit most from lower taxes?
Well, small-cap stocks have some of the best prospective returns.
After all, these companies have historically paid the highest tax rates simply because they don't have the big deductions and tax breaks offered to big Fortune 500 companies.
So it stands to reason, these companies have the most to benefit from the historic shift in corporate taxes.
If you want broad exposure to small cap stocks, a good place to start is the Russell 2,000 index. This index tracks 2,000 small cap stocks that are representative of the overall small cap market.
An easy way of gaining exposure to this index is to buy the iShares Russell 2000 ETF (IWM).
Of course, if you pick the best small cap stocks for your portfolio, you should do much better than the broad average.
This article originally appeared on The Daily Reckoning.