Over the years, the clients of Goldman Sachs have periodically found themselves on the verge of panic.
In March of 2015, we said that Goldman’s clients were most worried about the then-relentless crash in the EUR and how the resulting strong USD would hit US earnings (which, in retrospect, is ironic now that the tables have fully turned). Then In November 2015 we reported that “Goldman’s Clients Are Suddenly Very Worried About Collapsing Market Breadth” (and with good reason, the market was about to crash precisely for that reason). Several months later, Goldman’s clients were again confused – and worried – this time demanding that all their questions be answered before BTFD.
Then, in July 2016, Goldman’s clients again had a burning question: they were struggling to reconcile how extreme valuations of both equities and bonds can co-exist. As David Kostin explained one year ago, “client discussions reveal low portfolio risk coupled with concern that the rally lasts. Most investors have been skeptical of the valuation expansion and have not participated in the 8% rebound from the post-Brexit low on June 27. Upside call buying has been a popular strategy to insure against upside risk.” Additionally, Goldman clients were very worried that this remains a market without any earnings growth, and that much of the S&P upside has been due multiple expansion: “the S&P 500 forward P/E has already expanded by 70% during the past five years, exceeding all other expansion cycles except 1984-1987 (up 111%) and 1994-1999 (up 115%). Both prior extreme P/E multiple expansion cycles ended poorly for equity investors.”
While it is unclear if said clients got over their concerns and got on with the BTFD program, what we do know is that since last July, already extreme valuations have only gotten more extreme, and as a result, Goldman clients are once again very worried, this time about an “imminent equity downturn” (banker euphemism for crash).
As Goldman’s chief equity strategist, David Kostin writes in his latest Weekly Kickstart, “the question every client asks: “Is an equity correction imminent?”
He then concedes that “Of course, at some point the S&P 500 will retreat”… but then gives two (painfully laughable) explanations why not just yet. First, however, he lays out the 7 reasons why Goldman’s clients are so fearful:
- 1. History. Many investors argue the bull market is “long in the tooth” and will soon come to an end. It has been 14 months since the S&P 500 index experienced a 5% sell-off and 19 months since the market had a correction of 10%. The last bear market defined as a fall in the index greater than 20% ended in 2009. The current bull market has lasted for 8.5 years and the S&P 500 has climbed by 260% compared with a 124% rise in earnings and a 64% P/E multiple expansion to 18x forward EPS.
2. Volatility (or lack thereof). Realized 3-month vol is nearly the lowest in 50 years. Implied vol as measured by the VIX stands at 12, a 6th percentile event since 1990. In his recent book, Tectonic Shifts in Financial Markets, the legendary Salomon Brothers economist Henry Kaufman (with the superb sobriquet “Dr. Doom”) references the lesson of Sherlock Holmes in “The curious incident of the dog in the night-time” that what doesn’t happen matters as much as what does. Low volatility across asset classes may be masking risks that are not evident today but will be obvious in retrospect.
- 3. Valuation. Equity valuations are stretched on almost every metric. The typical stock trades at the 98th percentile and the overall index at the 87th percentile relative to the past 40 years. Only on a Free Cash Flow (FCF) yield basis is the market valued at an average level (4.4%). But as we detailed in a recent report, the collapse in capex spending explains the FCF yield. On a cash flow from operations basis the market trades at the 87th percentile. Other asset classes are also highly valued vs. history: nominal Treasury yields (92nd), real yields (75th), and HY (75th) and IG (69th) spreads.
- 4. Economics. The current US economic expansion just celebrated its 8th birthday making it one of the longest stretches without a recession. Only the 10-year expansion during 1991-2000 and the 9-year expansion from 1961 to 1969 had longer durations. The median length of the 16 expansions since 1921 has been 42 months. Along with the question about an equity correction, another frequent inquiry is “when will the next recession occur?” Our economists assign an 18% probability of a recession within 12 months.
- 5. Fed policy. The FOMC has lifted the funds rate by 100 bp since it started tightening in December 2015. During prior hiking cycles, equity P/E multiples typically fell but multiples have actually expanded during the past two years. Futures imply one hike by year-end 2018 vs. our economists’ estimate of five. The uncertain pace of further tightening is a cause of much investor anxiety.
- 6. Interest rates. Two months ago, Treasury yields equaled 2.4%, ten-year implied inflation was 1.7%, and the S&P 500 stood at 2410. Our year-end forecasts of a 2.75% bond yield and a 2400 level in the S&P 500 looked rational. However, weaker-than-expected inflation data sparked a 35 bp drop in bond yields to 2.05% and a 2% stock market rally to 2465 (+10% YTD). Looking ahead, we maintain our year-end 2017 target (-3%).
- 7. Politics. President Trump’s fluid positions on domestic policy disputes in Washington, D.C. and geopolitical gamesmanship with Pyongyang and Beijing make political forecasting a precarious activity. One fund manager cited the “Law of Conservation of Volatility” under which there is a finite amount of uncertainty in the world. All the risk is now concentrated inside the Beltway and volatility outside of politics is close to zero. Of course, this could change at a moment’s notice.
As Kostin further adds, “investors cite the points above to justify their forecast of a looming correction. According to their narrative, high valuation leaves little room for error. A Fed tightening despite low inflation will spark concerns about the sustainability of economic expansion and lead to a jump in vol that may be compounded by a political event that in turn will spark a wave of selling. As factors reverse performance, quant funds will liquidate positions putting additional downward pressure on share prices and driving indices lower.”
So what is Goldman’s response to these 7 very valid concerns? In a nutshell, “don’t worry and just BTD” or as Kostin puts it, “because investor euphoria is non-existent, an imminent start of a long decline seems
Skepticism abounds with normal 3% mutual fund cash positions. However, a sturdy consumer accounts for 69% of US GDP and buybacks remain persistent. Firms with high growth investment ratios have durable prospects even in the event of a market hurricane.
Sturdy consumer? Strong Buybacks? Has Kostin seen either of these two charts proving that neither of these statement is true, first the worst retail sales in nearly 4 years…
… or at least SocGen’s chart showing the biggest drop in buybacks since the financial crisis?
Maybe Goldman clients should add an 8th concern: a grossly incompetent advisor.
In any event, for those who enjoy having their hand held and buying stocks which trade at the 98th percentile in valuations, hoping for even higher prices, this is who Kostin “rationalizes” his grossly wrong assessment:
Although the preceding sequence of events could happen, we view it as a low probability event in the near-term for two key reasons:
First, investors are not complacent. In Sir John Templeton’s timeless observation, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Investors today are situated between skepticism and optimism. Few are euphoric as 27% of core managers are beating their benchmark. “Tormented bulls” best describes investor mentality. Alpha-seekers have normal cash positions (3.2% of mutual fund assets), active manager redemptions are offset by beta inflows (ETFs), and corporates continue to repurchase shares.
Second, US economic growth persists led by consumers that account for 69% of GDP. Monthly job growth has averaged 175K YTD, wages are rising (our leading indicator is a 2.7% rate), confidence is at the highest level since 2001, and household balance sheets are the strongest since 1980. For corporates, S&P 500 sales and EPS will rise by 5% and 7% in 2018. “Firms of tomorrow” with Growth Investment Ratios averaging 91% of CFO in past 3 years (vs. S&P 500 median of 17%) will grow 2018 sales and EPS by 7% and 12% and will outperform should a market hurricane occur (GSTHHGIR).
In short: yes, the market should crash, but because investors are not complacent (just don’t look at the VIX), and because the economy is so strong (just don’t look at the 10Y), everything will be fine. Surely this optimistic bias would lead Goldman to at least expect some upside from here in the S&P? Well, no:
- “We expect the S&P 500 will end 2017 at 2400 (-2.6)%.”
Dear David: a) you are not even trying any more, and b) in your next weekly letter, can you please just let us know how much more Goldman’s prop desk has left to sell before it pulls the rug out of the market. Thanks.