Posted by on November 23, 2017 9:02 pm
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Categories: 8.5% Barclays Bear Market Bond Business China Cognitive Dissonance Economy Equity Markets Equity premium puzzle European Central Bank Eurozone Fed Fund Finance Financial ratios france FTSE 100 germany Investment italy Market Crash Mathematical finance money Price–earnings ratio Recession recovery republican party Risk Premium S&P S&P 500 SocGen SSE 50 stock market Technical Analysis US Federal Reserve VIX Volatility

While the charade of sellside analysts releasing optimistic, and in the case of Barclays and Goldman rationally exuberant”previews of the year ahead…

… is a familiar, long-running tradition on Wall Street, rarely has the intellectual dishonesty and cognitive dissonance been quite so glaring: take Goldman, which while admitting that valuations have never been higher, and the upside case never more reliant on just one piece of legislation which has a significant chance of not passing (GOP tax reform for those unaware), Goldman still has to temerity to predict not only no bear market in the next three years, but goes so far as to suggest an “irrationally exuberant” target of 5,300 in three years.

And as of this morning, the penguins are on full parade, with virtually not a single big bank predicting the market will drop in the coming year. Here are the latest S&P price targets, EPS forecasts and implied PE multiples, for the year ahead:

  • Bank of Montreal, Brian Belski, 2,950, EPS $145.00, P/E 20.3x
  • UBS, Keith Parker, 2,900, EPS $141.00, P/E  20.6x
  • Canaccord, Tony Dwyer, 2,800, EPS $140.00, P/E 20.0x
  • Credit Suisse, Jonathan Golub, 2,875, EPS $139.00, P/E 20.7x
  • Deutsche Bank, Binky Chadha, 2,850, EPS $140.00, P/E 20.4x
  • Goldman Sachs, David Kostin, 2,850, EPS $150.00, P/E 19x
  • Citigroup, Tobias Levkovich, 2,675, EPS $141.00, P/E 19.0x
  • HSBC, Ben Laidler, 2,650, EPS $142.00, P/E 18.7x

Good luck with all those 20x P/Es in a world in which rates are rising and central bank balance sheets will start contracting in one year.

Luckily, there is the occasional honest bank, like Macquarie (whose Viktor Shvets has become one of our favorite commentators for his objective, no nonsence analysis) and – as of this morning – SocGen, whose strategist Roland Kaloyan has written a note which warns that with bond yields rising (see the crash in China overnight, where the Shanghai Composite tumbled the most in 17 months on the realization that rising rates is bad for stocks), there is effectively no upside left in stocks, which coupled with the prospect of a US economy recession in 2020 will “crimp returns in 2019” Furthermore, in light of the record vol shorts, SocGen jumps on the VIX-squeeze crash bandwaon, warning vol positioning could “strongly deteriorate the risk reward profile of equity markets.”

In not so many words: with little stock upside left, with the threat of rising interest rates slamming P/E multiples, with the economy in deep in late cycle, with equities trading at record valuations, with everyone short vol and just begging for a vol short squeeze, SocGen’s advice is simple: get out now.

Here is SocGen:

We are less enthusiastic about equities heading into 2018 – We do not see much upside on our major equity targets for the next 12 months. We expect stretched valuations and rising bond  yields to limit equity index performances in 2018 and the prospect of a US economic slowdown in 2020 to further cramp returns in 2019. We also raise some concerns about the quantity of shorts on volatility, which could potentially strongly deteriorate the risk reward profile of equity markets.

Specifically, with regards to the S&P, SocGen reports that US equities are now at – or rather about 100 points above – their fair value:

The S&P 500 has reached our target for the end of this cycle (2,500pts) and is now entering expensive territory. Indeed, on all the metrics, US equities are trading at levels only seen during the late-90s bubble. Since Trump’s election, the US equity market has risen 24%, but only half of this came from earnings growth. The other half has been driven by P/E expansion. According to our calculations, the US equity market is already pricing in potential tax reform. The rise in bond yields and Fed repricing should be headwinds against further US equity rerating.

If that wasn’t enough, SocGen also notes that its valuation model suggests “that upside on the S&P 500 is limited: the US equity market is already pricing in a rebound in growth and inflation. The rise in bond yields and Fed repricing should be a headwind against further US equity rerating.

In practical terms, this means that SocGen is predicting that the S&P, which is already 100 points above the bank’s year end target of 2,500, will tumble to 2,000, or more than 20%, before rebounding modestly to 2,200 just as the US economy succumbs to a recession, at which point all bets are off. And not just the S&P, but virtually all major European bourses are due for a bear market in the coming 12 months.

Here are some of the key arguments behind SocGen’s bearish outlook, first a familiar discussion of the risk posted by the biggest vol short ever observed.

Equity volatility, both realised and implied, has been edging ever lower for quite some time now. Being invested in a simple systematic short VIX future volatility has been strongly rewarding: +290% over the last two years. However, when the tide turns (i.e. VIX spikes), the drawdown can be significant. The quantity of short positioning on VIX open in the market (see right chart) would potentially amplify any spike of the VIX.

The risk of a VIX surge ties into the question of how the market’s risk/return profile will be shaped in the coming year based on what the prevalent VIX level is:

The risk /reward ratio as measured by the Sharpe ratio has been very attractive for US equities: good expected return supported by reasonable valuation and EPS growth, a very low Fed fund rate and an ultra-low volatility regime. At the current 12-month forward P/E, we factor in our Fed Fund scenario (2.25% by end-2018) and a different volatility regime. A change of VIX regime from 10% to 15% would push the US equity Sharpe ratio back to its historical average.

Then there is the already record stretched valuations, something even Goldman admitted earlier this week, with “US equities trading above their long-term average and at a level only seen during the dotcom bubble.

US equities have not been in attractive territory valuation-wise for a while. Indeed, on all the main valuation metrics, US equities are trading above their long-term average and at a level only seen during the dotcom bubble. However, expected earnings growth for the next 12 months (12%) is below the 20y annual earnings growth average (14%).

The last risk is that bond yields are going higher, forcing a contraction to PE multiples, as investors shift away from equities into bonds, as the dividend yield on US stocks at 2.0%, is now lower than the 10Y yield  of 2.3%.

Under our scenario, US Treasures will reach 2.70% at the end of 2018. This should be a headwind for equity markets. Indeed, our US equity risk premium is at 2.9%, one standard deviation below the long-term average . Any increase in bond yields would push the equity market further into expensive territory relative to bonds The dividend yield offered by US equities (2.0%) is already lower than the current US longterm bond yield (2.3%).

Finally, SocGen points out something that few other analysts  have admitted: half the S&P rally since the Trump election has been on the back of multiple expansion, with just 48% the result of earnings growth. Furthermore, as SocGen calculates, assuming tax reform passes, a decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months. In other words, contrary to conventional wisdom, more than 100% of Trump’s tax reform is already priced in.

Since Trump’s election, the S&P 500 has risen 24%. Only half of this performance has been driven by earnings growth; the other half is from P/E expansion. Assuming that analysts have not factored tax reform into their earnings forecasts, tax reform expectations have been the driver of P/E expansion. The S&P 500 index tax rate is currently 26.6%. Assuming that US companies generate 43% of their profits abroad (here) and pay 35% of their US profits on taxes (i.e. with no loopholes for US profits), the average tax rate outside the US would be 15.5%. A decrease in the US tax from 35% to 20% as planned by Trump’s tax reform would thus theoretically boost earnings by 8.5%. The 12-month forward P/E has risen 12% over the last 12 months.

Separately, turning to Europe, Socgen acknowledges the euro zone’s economic recovery is in full swing but – in yet another bearish thesis – argues that the current valuations don’t leave “much meat on the bone” and that the expected rise in the Euro could also weigh on exporters in particular, and European stocks in general. Additionally, with the European Central Bank set to progressively unwind its stimulus package, investors are increasingly wary of the amount of debt some companies have accumulated thanks to historically low interest rates.

Cable group Altice, whose shares have collapsed more than 50% in the last 30 days due to concerns on its €50 billion euros pile of debt, and whose debt plunge has been seen by some as the catalyst for the recent junk bond swoon, is an example of what is likely to come, Societe Generale said.

And while the French bank saw pockets of growth in Germany, France and in sectors such as financials, but warned that political risks are still present, notably in Spain with the Catalonia crisis and Italy which faces general elections in 2018. Oh, and the UK too: “We also recommend staying away from the UK as Brexit negotiations are accelerating and several scenarios are possible: only a soft Brexit would be supportive for the FTSE 100.

And yet, after all that, not even Socgen is willing to bite the bullet, and warn that ahead of what clearly is “a bear market is coming” call, investors should dump risk: so ingrained is the desire to run with the penguin herd, that even the most contrarian calls are doused in such a big layer of caveats, Arnold could easily driver his hummer on top of.

To wit: “But then again, should we be outright bears? After all, we do see some value pockets in the market and some specific themes (M&A, consumer in the eurozone).”

Which almost explains the report’s cover page…

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