It is the 24th of February 2020

The One Question Goldman's Clients Are Asking This Week: "Where To From Here?"

Two weeks ago, Goldman's clients were so worried about an imminent crash, the investment bank's chief equity strategist, David Kostin enumerated no less than 7 reasons why, as Goldman itself admitted, "the question every client asks: Is an equity correction imminent?” As a reminder, the reasons - summarized - were the following:

  1. History. Many investors argue the bull market is “long in the tooth” and will soon come to an end. 
  2. Volatility (or lack thereof). Realized 3-month vol is nearly the lowest in 50 years. Implied vol as measured by the VIX stands at 12, a 6th percentile event since 1990.
  3. Valuation. Equity valuations are stretched on almost every metric. The typical stock trades at the 98th percentile and the overall index at the 87th percentile relative to the past 40 years
  4. Economics. The current US economic expansion just celebrated its 8th birthday making it one of the longest stretches without a recession
  5. Fed policy. The FOMC has lifted the funds rate by 100 bp since it started tightening in December 2015. During prior hiking cycles, equity P/E multiples typically fell but multiples have actually expanded during the past two years.
  6. Interest rates. Two months ago, Treasury yields equaled 2.4%, ten-year implied inflation was 1.7%, and the S&P 500 stood at 2410.
  7. Politics. President Trump’s fluid positions on domestic policy disputes in Washington, D.C. and geopolitical gamesmanship with Pyongyang and Beijing make political forecasting a precarious activity.

Incidentally, like a good shepherd, Goldman quickly comforted said worried clients, giving two reasons why a crash is not imminent:

  • First, investors are not complacent. In Sir John Templeton’s timeless observation, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Investors today are situated between skepticism and optimism. Few are euphoric as 27% of core managers are beating their benchmark. “Tormented bulls” best describes investor mentality.
  • Second, US economic growth persists led by consumers that account for 69% of GDP. Monthly job growth has averaged 175K YTD, wages are rising (our leading indicator is a 2.7% rate), confidence is at the highest level since 2001, and household balance sheets are the strongest since 1980.

And, at least so far, Goldman has proven correct, with the S&P rising to new all time highs above 2,500 even as the Fed hiked rates one more time in the interim in an unexpectedly hawkish move which expects at least one more rate hike in December and 3 more in 2018.

So what are Goldman's clients worried about now? According to the latest note from David Kostin, what Goldman's clients want to know now that an imminent crash is no longer of concern, is "where to from here?" or as Kostin writes, "what is the likely path forward now that the 8½ year long bull market has lifted the S&P 500 index by 1824 points (270%) since its 667 low on March 9, 2009" and just broke the 2500 threshold for the first time and this week set a new high of 2508.

Or, in other words, "how should investors think about the next 100 point move?" Here is Goldman's answer:

The tactical near-term path of the market during the next few months will be determined more by a change in valuation (lower P/E multiple) as investors confront a higher prospective interest rate environment than a shift in underlying fundamentals such as a change in the sales, margin, or earnings outlook. This view explains our year-end 2017 target of 2400 (-100 points).

In terms of price targets, Kostin says that the forward path of S&P 500 during the next few years will be determined more by sales growth than a shift in valuation, however the Goldman analyst is hopeful that sustained modest economic growth will support top-line revenue growth. This view is the basis for Goldman's year-end 2019 target of 2600 (+100 points), while its year-end 2018 forecast of 2500 implies a flat 1-year price return, and Kostin expects that stocks with high expected sales growth will outperform during the next 12-months.

Before Goldman elaborates on what happens next, it first looks at how we got here:

Looking back at the drivers of the bull market reveals that higher profits contributed 1111 points (61%) of the index gain since 2009 as trailing EPS rose to $130 from $67. An improvement in expected earnings growth added 209 points (11%) of the 1824 point index gain as forecast EPS growth rose to 9% compared with -1% at the low in 2009. The higher valuation of the market accounted for 504 points (28%) of the overall index climb as the forward P/E multiple rose to 17.7x today vs. 10.1x at the trough (Exhibit 1).




Earnings growth since 2009 has been powered by a combination of changes in sales and margins. Margin expansion disproportionately explains the growth in profits. The more than 300 bp improvement in margins (to 10% from 7%) accounts for 80% of earnings growth for the S&P 500 index (excluding Financials, Utilities, and Real Estate). Sales growth contributed 20% of the overall earnings growth outside of the sectors above.


Summarizing the building blocks of overall EPS growth contribution to the 1824 point gain in the S&P 500 since 2009: roughly 30% stems from margin expansion, 8% from increased sales, and 23% from higher earnings in Financials, Utilities, and Real Estate (for a total EPS growth share of 61%).

With the past out of the way, here is Goldman's rather gloomy response to the question that keeps its clients up at night: "what will keep the market levitating higher?"

Looking forward, rising labor costs and interest rates are headwinds to further profit margin expansion. We assume margins climb by 20 bp to 9.9% in 2018 but slip to 9.8% in 2019. Our US Economists’ Wage Survey Leading Indicator stands at 2.7%. Their forecast of 5 hikes during the next 15 months compares with 2 hikes implied by the futures market. Our forecast is more hawkish than the path of the median estimate in the Fed’s Summary of Economic Projections (SEP) released this week. We forecast Treasury yields will reach 2.75% at year-end 2017, 3.25% in 2018, and 3.6% by 2019.


Similarly, we assign a low probability of further valuation expansion. The aggregate P/E multiple ranks in the 89th percentile vs. the past 40 years and higher interest rates typically correspond with lower valuations. The S&P 500 currently trades at 18.0x our top-down 2018 EPS forecast of $139 and 17.2x bottom-up consensus of $146. By the end of next year, the P/E on our top-down 2019 estimate of $146 will be 17.1x, one point below today.


Absent support from improving margins or P/E multiple expansion, equity returns are likely to be dependent on sales growth. Our baseline forecast is revenues grow by 4.7% in 2018 and 4.5% in 2019. Our top-down sales model specifies 5 macro variables that have historically driven revenue growth.


None will spark acceleration in sales growth during the next 3 years.

  • 1. US GDP growth: Our US economics team forecasts GDP growth of 2.4% in 2018 and 1.7% in 2019. Although above the trend growth rate of 1.75%, the modest pace of expansion is unlikely to accelerate S&P 500 sales growth.
  • 2. World GDP growth: We forecast global GDP growth of 3.9% in 2018 and 2019. Although recent data has been encouraging, 71% of S&P 500 sales is domestic, dampening the possible sales tailwind from faster non-US growth.
  • 3. Inflation: Inflation as measured by core PCE has remained below the Fed’s 2% objective for more than five years. Our economists forecast core PCE inflation will accelerate to 1.9% in 2018 led by services inflation (+2.6%).
  • 4. US Dollar: Our FX strategists expect the trade-weighted USD will rise by 2% through 2019, creating a slight drag on S&P 500 sales growth.
  • 5. Crude oil: Our Commodity strategists expect WTI and Brent will average $55 and $58/bbl through 2019 suggesting a shallow trajectory for Energy sales. Passage of tax reform represents an upside risk to our margin and EPS forecasts. The Senate may have reached a deal to include instructions in the budget resolution to cut taxes. Every 1 pp in rate reduction equals $1 in EPS.

Amid such a downbeat environment, one in which margin expansion is unlikely, in which P/E multiples will contract, and where sales growth is unlikely, it is no surprise that Goldman's conclusion is that "stocks with the best sales growth will outperform."

Our rebalanced 50-stock sector-neutral High Revenue Growth basket comprises firms with the fastest sales growth in 2018. Median constituent has forecast sales growth of 14% next year vs. 5% for the median S&P 500 stock. Basket has returned 20% YTD vs. 13% for S&P 500. PEG ratio equals 1.3x vs. 1.8x for the S&P 500.

It also explains why Goldman has pretty much given up hoping for any equity upside in the US, expecting a 100 point drop by year end, an unchanged market by the end of 2018, and a measly 100 point increase in just over two years, with the S&P closing 2019 at 2,600.

What is more surprising, is that following last week's admission by Goldman again that its bear market risk indicator surged to the highest since 2000 and 2007, and now implies a 67% probability of a market crash, that Kostin does not even contemplate the possibility of a much sharped drop in the market over the next two years...

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