The Seven Questions Goldman’s Clients Have About “Rational Exuberance”
In mid-November, just days after Barclays released its 2018 equity outlook with the title “Rational Exuberance”…
… Goldman’s David Kostin decided that imitation was the sincerest form of unveiling a non-contrarian year-end forecast, and in presenting his revised S&P price target for 2018 of 2,850 – which accounts for GOP tax reform – “borrowed” the Barclays title for his own year ahead preview…
… despite admitting that valuations have never been higher, thus suggesting that contrary to the title, the exuberance is anything but rational.
To be sure, despite their hyperbolic titles, both Barclays and Goldman simply went with the sellside flow: in fact, in addition to Barclays and Goldman, Wall Street strategists polled by Barron’s said they expect about a 7% S&P gain for 2018 same as basically every single year, according to Sentiment Trader who points out that “they’re not stupid, they go with the base rate.” Indeed, there is power in numbers, because if everyone is wrong about the year ahead, it is the same as nobody being wrong, something Wall Street discovered in 2007.
And yet, with not one but two banks mangling Alan Greenspan’s infamous words to justify their late cycle bullish outlook which both admit is not deserved on a fundamental basis, Goldman’s clients remain confused, and in his Weekly Kickstart, Goldman’s chief equity strategjst David Kostin writes that he has spent the last two weeks meeting with investors to discuss his outlook for US equities in 2018, including the impact of tax reform.
“Our Nov. 21 report, entitled Rational Exuberance, describes our expectation that 14% EPS growth, driven by healthy economic growth and a 5% boost from tax reform, will lift the S&P 500 index to 2850 by year-end 2018 (+8%).”
While it will hardly come as a surprise, Kostin confirms that as we reported last week most investors remain exceptionally bullish despite the all time high in the S&P and despite record valuations, instead betting that the Fed will always step in to keep the upward mometum in risk assets; still while “most clients agree with our bullish sentiment but they questioned several of our specific views.”
Below Kostin addresses seven of the most common investor questions prompted by his forecast, or specifically the things Goldman’s clients think is irrational about “rational exuberance.”:
1. How can you be “rationally exuberant” about the path of US stocks in 2018 when equity valuations are so high? Although the median S&P 500 stock trades in the 99th historical valuation percentile, valuations are typically poor indicators of short-term returns. Moreover, in contrast to the “irrationally exuberant” market of the late 1990s, today’s equity valuations are justified by a macro environment of extremely low rates, modest inflation, high corporate profitability, and a stable economy. Nonetheless, earnings growth, rather than higher valuation, drives our 2018 forecast.
2. If the out-of-consensus US Economics forecast for the Treasury yield curve is wrong and rates stay low in 2018, could equity valuations rise further? The “melt-up” scenario of a forward P/E that rises to 19x or 20x is possible, but unlikely. Our forecast for a stable 18x forward P/E multiple at year-end 2018 assumes the economic expansion continues, ROE rises, and the equity risk premium (ERP) narrows. However, in contrast with market pricing (2 hikes) and almost every client we have met (2 or 3 hikes), our economists expect the Fed will raise rates four times next year as the labor market tightens and inflation firms. A rising term premium should lift the 10-year Treasury yield to 3.0% and restrain further P/E multiple expansion.
3. Why did you downgrade the Information Technology sector when it has twice the sales growth and twice the margins of the rest of the S&P 500? The Tech sector’s low effective tax rate (19% vs. 26% for the S&P 500) means it has little to gain from tax reform. Recent performance supports our view. Regulatory risk is another reason for our downgrade. However, we recommend a Neutral weight (24%) in the sector due to strong fundamentals. Investors with sufficiently long investment horizons may find policy-driven weakness an opportunity to add to positions in the sector’s strongest secular growth constituents, which we believe remain attractive. We recommend overweight positions in Financials and Industrials. Both sectors pay above-average effective tax rates and are likely beneficiaries of tax reform. In addition, each sector has fundamental tailwinds such as deregulation and rising capex spending that should boost earnings in 2018.
4. Following value stock outperformance during recent weeks, do you still recommend growth as a style in 2018? Concentrated positioning and correlation with the Technology sector are clearly short-term headwinds to growth stocks. In fact, the acceleration in already-strong US economic activity should have led value stocks to perform even better than they have during the past several months (Exhibit 2). However, our economists’ forecast of 2.5% US GDP growth in 2018 portrays an economic environment typically conducive to growth stock outperformance and suggests that our sector-neutral growth factor should fare well during the course of the year.
5. Is the equity market already pricing the full impact of tax reform? The prediction market shows roughly 80% odds of passage. Equity market indicators such as Altaba (AABA) and our High Tax Rate basket (GSTHHTAX) send broadly similar signals. However, lingering uncertainty regarding both the provisions that will be included in the final legislation as well as the potential impact of several proposals, such as limiting interest deductibility and the treatment of cross-border transactions, suggest more rotation at the industry and stock levels remains in store.
6. What does the Senate proposal to delay the tax rate cut until 2019 mean for S&P 500 earnings and performance? The delay in rate cut until 2019 will save roughly $140 billion in government revenue but weigh on 2018 EPS as firms face several base-broadening provisions without the offsetting benefit of the rate cut. However, we expect the net 5% boost to future earnings will be unaffected, as would our 2019 EPS estimate of $158. The likelihood that companies pull forward capex and other expenses into the higher-tax year of 2018 may even boost economic activity and provide a net 2019 earnings benefit to S&P 500 companies beyond our current f orecast. In total, particularly against a backdrop of low discount rates, we expect little impact on stock performance from a potential delay in tax cut.
7. How big a risk to EPS is the Senate’s proposal to limit interest deductibility at 30% of EBIT? The proposal would have a minor impact on S&P 500 firms but pose a greater risk to more highly-levered small-caps. Consensus 2018 estimates show 5% of S&P 500 constituents but 15% of the Russell 2000 paying interest expense above 30% of EBIT. However, the proposal suggests incremental downside risk to buybacks and credit issuance as companies adjust corporate structures in response. In addition, the pro-cyclical proposal would have a much greater potential effect on US firms in environments of higher rates or weaker earnings; the current ratio of S&P 500 interest expense to EBIT is nearly the lowest in at least 35 years.
Finally, for those who have missed the barrage of year-ahead outlooks from Goldman in the past two weeks, here is a summary of what the world’s most influential bank believes will happen in the next 12 months: “We forecast the S&P 500 index will rise by 8% to 2850 by year-end 2018. EPS will benefit from tax reform and climb by 14% to $150 while the forward P/E multiple remains stable near 18x. Growth style will prevail over value and Industrials and Financials will outperform while Consumer stocks lag. Thematically, we prefer firms that prioritize investing for growth via capex and R&D. Most clients agree with our bullish sentiment but they questioned several of our specific views. Investors have a less hawkish view than Goldman Sachs economics on the bear flattening of the yield curve and implications for equity valuation and continue to focus on the implications of tax reform.”