Last weekend, Goldman's clients were nervous: after 16 months without a 5% pullback in stocks, they were afraid that a steep correction could take place at any moment.
Today, they are just as afraid, but have no choice other than to remain invested and buy every dip, or as Goldman's credit analyst Charles Himmelberg writes, "they characterize themselves as “reluctant bulls”, a view for which we have a lot of sympathy. While valuations are stretched, growth is strong and none of the major sectors in the US economy show much sign of critical imbalances that might lead to recession."
Rereading that sentence, "reluctant bulls" is probably not the best designation because when it comes to trading decisions Goldman clients are becoming "schizophrenic", and with reason: as Himmelberg explains there are reason to be both bullish and bearish. First, the generic reasons behind the endless "risk on":
In favor of continued “risk on” positioning, none of the major sectors in the US economy show much sign of critical imbalances. Indeed, the balance sheets of US households have been de-levering, and the stance of fiscal policy appears more likely to ease than to tighten from here. Corporate balance sheets have deteriorated, but interest coverage ratios remain comfortable and highly sustainable assuming the economy avoids recession. Even in the labor market, where the unemployment rate of 4.2% has arguably already fallen below its long-run sustainable level, wage growth is still well below an obviously unsustainable level.
So much for that, literally: what is interesting is how much more space Goldman dedicates to the bear case, or as the FDIC-backed hedge fund calls it, "reluctance is nonetheless highly warranted, in our view, for two reasons."
First, record high valuations, or "the high level of equity multiples (especially on a cyclically-adjusted basis)" means that "a continued rally in equities from here is heavily levered to higher earnings. While our colleagues in equity strategy expect continued growth in earnings per share, there are good macro reasons to think the risks to this view are skewed to the downside."
In this context, Goldman's biggest concern is the threat to record corporate profitability: Himmelberg writes that while corporate profit margins have benefited during the post-crisis period from the fact that real wages have lagged behind average labor productivity, "with the labor market heating up, inflation still in check and productivity growth still low, the macro drivers of corporate profit margins all appear headed in the wrong direction."
Another big concern is the Fed's tightening process, and that "it generally pays to worry about 'late-cycle hiking cycles'. As Rudi Dornbusch once wrote, “…none of the postwar expansions died of natural causes – they were all murdered by the Fed over the issue of inflation”. Here we see some room for optimism. Since inflation expectations appear to have become exceedingly well-anchored over the past decade, there is less need for “pre-emptive” rate hikes aimed at stopping inflation before inflation expectations get out of hand. Today, the Fed can afford to move more cautiously."
That said, absent a burst in runaway inflation - or at least its accurate measurement - the Fed can afford to not only slow down but put the tightening cycle in reverse, by merely uttering the beloved phrase "QE4" and all shall be well, as Bullard knows too well.
Consistent with this view, we forecast rate hikes at a pace of 25bp per quarter next year, roughly half the pace of past hiking cycles. To the extent that the data dependency of the Fed’s stance remains more backward-looking and reactive than forward-looking and pre-emptive, the risk of accidentally “murdering” this expansion should be correspondingly lower. Given that more aggressive rate hikes peaked within 1-2 years of the past three recessions, markets are likely not wrong to take some comfort from the relatively cautious pace of the current hiking cycle.
Even so, there are risks: "the path ahead for monetary policy is not completely clear. For one, quantitative tightening (QT) may yet pose problems. When we query clients, quantitative easing (“QE”) invariably ranks high on the list of reasons for inflated asset market valuations. As such, there is ample reason to worry that its removal poses a non-trivial risk to market sentiment."
To be clear, we expect the effects of QT to remain exceedingly modest. With shorter-maturity Treasury yields still at historically low levels, the practical difference between holding “money” vs “near-money” assets has rarely been smaller. And, so far, in the US the transition to QT has been drama-free. Indeed, as shown in Exhibit 1, the early days of QT in the US have seen a tightening of the mortgage basis. And looking ahead, we estimate the cumulative impact on 10-year Treasuries will be just 20-25bp through the end of 2018.
Of course, it's not just the Fed's balance sheet that matters, but - as we have frequently pointed out - that of all the central banks; This, too, appears to be a concern for Goldman clients:
investors often point to data such as that shown in Exhibit 2, citing the continued rise of global QE. Here again, we doubt that the global inflection, when it comes, will be any more disruptive than balance sheet normalization has been in the US thus far. But market narratives may dominate our rational analysis. If markets believe that global QE has been an important driver of the current rally, then its impending removal may nonetheless pose a psychological risk to investor sentiment.
There is one final risk that is keeping Goldman's clients on edge: Fed Chair Powell could surprise everyone, and end up not being the Yellen "continuity" candidate everyone expects:
Finally, the impending transition to a new Fed Chair may provide another reason for risk longs to feel “reluctant”. If Jerome Powell becomes the Trump administration’s candidate to replace Janet Yellen as Fed Chair today, we would expect policy continuity. That said, markets will need time to form a new “narrative” and belief system about the new Fed Chair. During this period, the risk of miscommunication will inevitably be higher. In particular, while Mr. Powell has said he does not view valuations or credit growth as problematic, he has argued that financial stability considerations could justify continued tightening in the future.
Goldman's conclusion: "While being long is likely still the right trade given that there is no obvious end to this expansion in sight, there are nonetheless legitimate reasons to be reluctant."
Or, roughly translated, do nothing and stay long even though "there are legitimate reasons" to sell.
In retrospect, perhaps the right word to describe the vampire squid clients' mental state is not "schizophrenic" - the best description of those who heed Goldman's advice - to do nothing - is "paralyzed", a term we first introduced in July, unable to move, or trade, thanks to the constant noise from all the conflicting narratives they are bombarded with daily amid the relentless market levitation that just drags you in deeper and deeper. The question is what happens when the paralysis finally lifts and the selling begins.