Goldman's Bear Case In 7 Steps: “We Are In The 98th Percentile Of Historical Valuations”
Having been on the fence about an upside case for the S&P for the greater part of 2016, Goldman’s chief equity strategist David Kostin finally threw in the towel earlier this week when, as we reported, Goldman raised its S&P price target from 2,100 (as of year end 2016) to 2,400 for mid-year 2017 on what it calls “Trump Hope” (as apparently does everyone else, see “The World Has Changed” – Average S&P Target Before Trump: 2,087; After Trump: 2,425“), which it then sees dipping to 2,300 by year-end 2017 on “Trump Fear.”
Having explained what “Trump Hope” means before, here is a quick recap of what “Fear”, according to Goldman Sachs whose former partner Steve Mnuchin will be running the US Treasury, looks like: by mid-2017 inflation will reach the Fed’s 2% target, labor costs will be accelerating at an even faster pace, and policy rates will be 100 bp higher than today. Rising inflation and bond yields typically lead to a falling P/E multiple. Congressional deficit hawks may constrain Mr. Trump’s tax reform plans and the EPS boost investors expect may not materialize. Potential tariffs and uncertainty around other policy positions may raise the equity risk premium and lead to lower stock valuations in 2H.
And here are the details, where as Goldman politely puts it, is where the “devil is to be found.”
First, as Goldman warns, while investors have been focusing on the prospect of a lower statutory corporate tax rate, the firm’s US economist Alec Phillips notes that it will likely come with provisions that will offset much of the benefit of a lower rate. For instance, under the House Republican plan, several corporate tax incentives, such as the interest expense deduction, would be repealed. Furthermore, the plan proposes a redefinition of foreign and domestic income based on where sales, rather than production, occurs. Furthermore, under Mr. Trump’s plan, the deficit as a percentage of GDP would jump from 3.2% in 2016 to 5.0% in 2017 and 6.1% in 2018. The annual deficit will rise from a projected $590 billion in 2016 to $960 billion in 2017 and $1.2 trillion in 2018. Our US economics team has a more restrained baseline forecast that projects the deficit as a percentage of GDP will be 3.4% in 2017 and 4.0% in 2018 while the deficit will total $650 billion in 2017 and $800 billion in 2018.
Second, another key risk of President-elect Trump’s proposed economic policies is higher inflation. Realized measures of inflation have steadily risen in recent months. Core CPI now stands at 2.2% while core PCE, the Fed’s preferred inflation metric, has risen to 1.7% from 1.3% last year (see Exhibit 24). At the same time, reduced labor market slack has supported wage growth and our GS Wage Tracker stands at 2.6%, its highest level post-crisis (see Exhibit 25).
Third, the bond market has started to price in a macroeconomic landscape of higher inflation and interest rates. Ten-year forward inflation expectations rose by 20 bps to 1.9% in just two weeks following the election (see Exhibit 26). Higher expected inflation has pushed 10-year nominal interest rates to 2.3%, an increase of 50 bp in just a few weeks. Looking forward, Goldman’s Economics team and the market expect bond yields will rise in 2017. Additionally, Goldman expects the short end and long end of the yield curve will rise faster than currently priced by the market (see Exhibit 27). In other words, the Fed is now behind the curve, pardon the pun.
Fourth, with the 10Y yield coming just shy of 2.50% on Thursday, financial conditions as dictated by the bond market are tight enough to start pressuring stocks. Recall that as Goldman also explained last week, “a rise in US bond yields above 2.75% would create a more serious problem for equity markets: at that point we would expect the correlation between bonds and equities to be more positive – i.e., any further rises in yields from there would be a negative for stock returns.”
Fifth, as inflation expectations and yields rise, Goldman expects higher realized inflation and interest rates will restrict any S&P 500 valuation expansion during 2H 2017. The S&P 500 forward P/E has already increased by 71% since September 2011, growth surpassed only by the 1987 cycle (112%) and the Tech Bubble (115%). Historical P/E expansion cycles are usually accompanied by falling interest rates and falling inflation while Goldman now projects both bond yields and inflation will rise during the next several years (see Exhibit 28). Although the S&P 500 trades at roughly fair value relative to history given core CPI of 2.2%, higher inflation is typically associated with a lower forward P/E multiple (see Exhibit 29).
Sixth, higher bond yields are usually associated with a lower forward P/E multiple. Since 1976, the average forward P/E multiple when the 10-year US Treasury ranges between 2% and 3% is 14.2x. However, the S&P 500 currently trades at 17.1x forward bottom-up consensus EPS and we expect some downside risk to the multiple as bond yields continue to rise during 2017.
Seventh, and last, despite Goldman’s recent bout of euphoric optimism, predicated only by the outcome of a presidential election which, as Goldman itself said, is very much unclear, the firm clearly admits that, and we quote, “S&P 500 valuation is stretched relative to history on nearly every fundamental metric. At the aggregate level, the S&P 500 index trades at the 85th percentile of historical valuation relative to the past 40 years. For portfolio managers, the more important fact is that the median S&P 500 company trades at the 98th percentile of historical valuation (see Exhibit 33).”
… So you’re saying there is a 2% chance?
Joking aside, one quick look at the table below shows that the market would be the most overvalued ever if it wasn’t for just one metric: Free Cash Flow Yield. Well, don’t look for cash flows to go up once interest rates start rising, as they are doing right now.
And yet, despite all of the above, Goldman is telling its clients to buy all those stocks which Goldman’s prop traders (because as we now know, despite Volcker, Goldman has been quietly cultivating an army of prop traders just for this purpose) are actively dumping.To wit:
We expect the 10-year US Treasury yield will end 2017 at 2.75% and the yield gap will narrow to 285 bp. The resulting earnings yield would equal 5.6%. Applying a P/E of 18x to our 2018E adjusted EPS estimate of $129 implies a S&P 500 index level of roughly 2300.
In retrospect, there is a reason why Goldman calls its clients “muppets.”