It's confusing to be a Goldman client these days.
One month after the investment bank reported that its Bear Market Risk indicator had jumped to 67%, a level it hit most recently before the dot com bubble crash and just before the global financial crisis and prompted Goldman to ask "should we be worried now"...
... Goldman's chief equity strategist, David Kostin, nearly admitted capitulation on his bearish year-end S&P price target of 2,400 (which rises to 2,600 by year end 2019, or just 25 points from current levels!), writing last week that "the 2400 target assumes no reform and P/E of 17.3x. 65% probability of passage by 1Q." However, "with tax reform, target could be 2650 (17.9x)." Even so, Kostin still conceded that both the S&P 500 and the median stock trades at high valuations (the latter at the 98%-percentile of historical records), with the exception of free cash flow yields, which he explained is artificially low due to companies' unwillingness to spend on capex.
So on one hand, there is a broad consensus that stocks are massively overvalued, there are also concerns that the market is poised for a bear market, if not worse, and all this takes place 30 years after Black Monday. On the other however, Goldman refuses to cut its tactical outlook on stocks, and despite predicting a 6% drop by year end, cautions that stock may keep rising, if only on expectations of tax reform getting done, which will push stocks even higher, to 2,650 or more.
In this context, it is probably not surprising then that as Goldman's David Kostin writes in his latest Weekly Kickstart report that "In the ninth year of economic expansion, with S&P 500 up 15% YTD, the most common question from clients is, “When will the rally end?”
Here are the details from the latest round of conversations Goldman had with its clients, which it summarizes as "peak growth and drawdown potential."
Thursday marked the 30-year anniversary of Black Monday. On October 19, 1987, the S&P 500 plunged by 22%, its worst single-day return on record. Following the decline in global equity markets, it took the S&P 500 a full year (October 20, 1988) to regain its pre-crash level. This week also marked 20 months since the last 10% S&P 500 correction and 16 months since the last 5% drawdown. This ranks as the fourth longest streak in history (behind 17-19 months in 1965, 1994, and 1996) and at 332 trading days is well above the historical average of 92 days (see Exhibit 1).
In the ninth year of economic expansion, with S&P 500 up 15% YTD, the most common question from clients is, “When will the rally end?”
Of course, it's not just Goldman clients who want the answer to that question: virtually everyone, and perhaps even the Fed, is curious how much longer can risk assets defy the forces of gravity and plow onward to new all time highs. Obviously, it's virtually impossible to give the correct answer, although Kostin's response suggests that the inflection point is approaching:
Catalysts for equity market corrections are notoriously difficult to identify ex-ante. In fact, catalysts can even be difficult to identify in retrospect; historians still debate the cause of the Black Monday plunge although portfolio insurance is viewed as the reason the collapse was so dramatic. We do not expect an imminent drawdown, but the risks identified most frequently by clients may limit medium-term S&P 500 upside.
As a reminder, "drawdown" is a polite, sellside way of saying the c-word. So what are Goldman's main "drawdown" considerations?
Economic growth is the most important driver of corporate earnings and equity performance. Since the Tech Bubble, S&P 500 returns have generally tracked the pace of US economic activity as captured by the ISM Manufacturing Index. After dipping in 2Q, the index has surged in recent months and in September hit 60.8, the strongest reading in 13 years (since May 2004). The US acceleration matched a surge in global growth; our global Current Activity Indicator shows a 4.9% pace of real economic growth, nearly the fastest in five years.
Although economic data are extremely strong now, an ISM reading above 60 typically marks the peak of growth and presages economic and equity deceleration. Since 1980, the ISM has exceeded 60 in eight separate episodes; four of those lasted only one month. Investors buying the S&P 500 at ISM readings of 60 or higher have gone on to suffer negative three- and six-month returns on average as economic activity slowed (see Exhibit 3). In other words, an environment of synchronized global growth acceleration today raises the risk of coordinated global slowdown tomorrow.
So if the current 61 print in the ISM Mfg survey is indeed a leading indicator of a market top, how much downside does Goldman expect based on historical data, all else equal? According to the chart below, a modest drop in the next 3-6 months is to be expected, although certainly not a crash, pardon substantial "drawdown".
It's not just the ISM which is topping out. According to Goldman economists, US GDP will continue to grow at a healthy rate but decelerate from 1H 2017. Kostin writes that following 2Q GDP growth of 3% and September US CAI at 3.6%, they forecast real GDP growth of 2.5% in 2018. "Our economists also estimate that easing financial conditions this year have boosted GDP growth by 50-100 bp. This tailwind is unlikely to persist as the Fed continues to tighten. However, in the near term investors may discount any volatile economic data releases as a consequence of recent hurricanes."
However, it is neither the topping ISM, nor the modest slowdown in predicted GDP that is most concerning to the Goldman strategist, who warns that "the biggest risk to equity market valuation is rising interest rates."
Our economists believe that the Fed will hike in December and four times next year, while market pricing implies 2-3 by year-end 2018. Rising rates should weigh on equity valuations, just as P/E multiples compressed during the last three hiking cycles. However, since the Fed began hiking in December 2015 the S&P 500 forward P/E multiple has expanded by 10% to 18.5x.
In summary, and this is hardly rocket science, "rising inflation data or a hawkish shift in messaging from any of the major global central banks could lift long-term bond yields and spark a sharp valuation unwind."
Or not, because as BofA's Michael Hartnett wrote on Friday, the absence of inflation, and especially wage growth, could be the catalyst that forces bonds bears to capitulates, sending 30-year Treasury yields toward 2%, the Nasdaq toward 10,000, and high yield & Emerging Market bond spreads 100bps tighter. "The outperformance of “deflation” versus “inflation” could turn exponential."
Putting all this in simple English, the longer the Fed's attempts to create economic inflation fail to, well, create inflation - in the real world - the bigger the financial asset bubble the Fed has created will become; meanwhile as we showed recently, the difference between inflation in the "real economy" and hyperinflation in the asset prices, has already hit record levels.
Meanwhile as Goldman admits that downside risks are mounting, it can't leave its outlook on a sour note, which is why Kostin reverts to the concept of the "Schrodinger market", one where the year end price target for the S&P depends on whether or not republicans will get the tax deal done:
Tax reform remains the key potential upside and downside risk to equity markets. Our political economist sees a 65% probability that tax cuts are passed in early 2018. We estimate tax cuts could lift 2018 EPS by 7% to $148, suggesting that tax reform optimism has contributed to the 5% S&P 500 rally since late August. If developments in Washington lift the odds of tax reform closer to 100%, or hint at larger cuts than we currently expect, S&P 500 could continue to rise toward 2650. On the other hand, a collapse in expectations would likely mean the reversal of the market’s recent 5% rally.
Finally, here are two more reasons why, even in a worst case scenario, Goldman does not expect a market correction, imminent or delayed, to be dramatic: someone Goldman once again tries to pass off the claim that everyone remains too cautious, which provides "limited downside from any economic or policy-related disappointment", and the second reason is that corporations will unleash stock buybacks on even a modest decline.
More on the first:
Persistently cautious investor sentiment is one reason we expect limited downside from any economic or policy-related disappointment. After spending 12 straight weeks above 90, our Sentiment Indicator now stands at 87 out of 100 (page 14). Client conversations reveal investors probing for reasons the market may turn lower. As noted, the lack of investor “euphoria” typical of bull market peaks is one argument against major market downside. Of course, cautious sentiment did not prevent the decline 30 years ago: today’s AAII bull (38) and bear (28) sentiment readings are remarkably close to the levels of 37 and 33 in mid-October 1987.
Here we can add that the "lack of euphoria" argument is, at this moment, utter rubbish. Not only are such metrics as CNN's bull and bear "Greed" indicator near all time highs, but according to the latest UMichigan survey, American households said that the probability of an increase in stock prices in 1 year is the highest in history.
That said, we do agree with Goldman that if markets finally do crash, corporate treasurers will be busy issuing debt and buying back stock with the proceeds:
Ample buyback capacity also reduces the risk of near-term drawdown. Policy uncertainty and lack of “dip” to buy explains the 16% fall in S&P 500 buybacks in 1H 2017 vs. 1H 2016. However, authorizations are up 18% YTD. Weak stock prices would be countered with buybacks, buffering downside.
Considering there are virtually no aggregate shorts left, this is perhaps the most credible argument for what could arrest a sharp market drop, aside from central banks directly intervening in the market of course. Recall that as we reported several months ago, when one nets out all capital flows since the financial crisis, there has been just one buyer of stocks: Companies themselves.