After recent (and in some cases very dramatic) bearish conversions by the likes of JPM, BofA, Citi and UBS, the only bank that steadfastly held a bullish view on stocks during the recent market squeeze higher was Goldman Sachs.
Not any more.
On Thursday, Goldman strategist David Kostin appeared on CNBC, where he too join the bearish crowd and said that based on the threat of margin collapse (“35 out of 53 tech companies had margin declines”) and record-high stock valuations this year, it’s time to play defense in “a tough market.”
He also hinted that with 80% of fund managers underperforming their benchmark, the probability of irrational capital allocations increases, and as a result there is a “reasonably high probability” of a large drop (or “drawdown” as a sudden plunge is called in polite circles) in the S&P500 ahead of his year-end 2100 price target.
Then overnight, Kostin dedicated his entire weekly kickstart piece to just the topic of a drawdowns, saying that “Unbalanced distribution of upside/downside risks suggests “sell in May” or buy protection.” He adds that “we continue to expect S&P 500 will end 2016 at 2100, roughly 3% above the current level. However, a shift in investor perception of various risks could easily trigger a drawdown.”
Goldman’s stark and unexpected warning is driven by risks which include “elevated valuation, investor positioning, money flow trends, uncertain interest rate policy, weak economic growth, and election year politics. A 5%-10% drawdown in S&P 500 during the next few months implies an index level of 1850 to 1950 and a forward P/E of 15x-16x based on bottom-up consensus EPS.”
Of course, a 10% market drop never ends on a dime, especially in a market as illiquid as this one, and if the recent warning by JPM’s Marko Kolanovic is correct, should stocks stumble by 10% in the absence of another round of central bank intervention, we may be looking at the first official market crash in the post-crisis era.
And just like that Goldman has joined the bearish camp.
To be sure, for Goldman faders and contrarians, this may be the most bullish catalyst yet because after the anti-Dennis Gartman ETF, doing the opposite of what Goldman recommends has historically been the most profitable trade.
Still, perhaps this time Goldman is not seeking to unload its book on muppets. Here is the full reason behind Goldman’s bearishness.
Following a tumultuous first quarter, S&P 500 has stabilized in 2Q 2016. Realized volatility averaged just 10 in April, the lowest level since May 2015. Implied volatility as measured by the VIX averaged 23 during the first two months of the year before retreating below 15 in May. Equity investors seem complacent rather than bullish about the near-term prospects for US stocks.
Looking over the horizon for the next few months, we see a variety of risks that lead us to revisit the adage and ask whether investors should “sell in May and go away” and not return until after Labor Day.
A drawdown during the next few months could find the S&P 500 index falling by 5%-10% to a level between 1850 and 1950. 16 drawdowns greater than 5% have occurred since 2009, including the 13% market correction that lasted 3 months and ended in February (Exhibit 1). S&P 500 trades at 2047 and has a forward P/E of 16.7x based on bottom-up adjusted EPS of $123. A 5% pullback would lower the P/E to 15.8x, implying an index level of 1950. A 10% correction would reduce the P/E to 15.0x and the index level to 1850.
We continue to expect the S&P 500 index will end 2016 at 2100, roughly 3% above the current level. Not all is bleak, with possible upside arising from the recent trend of positive earnings revisions, as discussed last week, along with the possibilities of investors adding more length and a dovish Fed surprise in June. However, upside/downside risks are not evenly distributed. S&P 500 will likely experience at least one drawdown between now and year-end. We recommend selling upside calls to fund downside protection given the options market prices a below-average probability of a 5%-10% drawdown during the next three months (see Exhibit 2).
The six “known known” risks listed below are currently quiescent but investor perception could easily shift and trigger an equity index drawdown.
1. Valuation is a necessary starting point of any drawdown risk analysis. At 16.7x the forward P/E multiple of the S&P 500 index ranks in the 86th percentile relative to the last 40 years. Most other metrics paint a similar picture of extended valuation. The median stock in the index trades at the 99th percentile of historical valuation on most metrics. The most likely future path of US equities involves a lower valuation.
2. Supply and demand trends also suggest downside risk. During the first quarter, the lack of investor positioning in domestic equities was the most bullish argument for a share price rally. Even as the S&P 500 index rebounded from its February 11 low, institutional and hedge fund US equity futures positions remained net short and our Sentiment Indicator hovered near 10 (out of 100, see page 5). A low sentiment reading represents a bullish trading signal for the subsequent 4-6 weeks. Sentiment has shifted sharply during the past few weeks. Since the end of March, investors have bought $23 billion worth of futures positions, lifting our Sentiment Indicator to 32, a less bullish level compared with mid-winter.
3. Corporate buybacks represent the single largest source of equity demand but may wane during coming months. Most firms completed 1Q earnings season by early May and have now resumed their discretionary buybacks, providing near-term support for the market. The month of May typically witnesses 10% of annual repurchase spending. However, spending normally decelerates in June and again in July, when just 7% of buybacks occurs as companies enter a blackout window ahead of 2Q earnings reports.
4. The fed funds futures market currently implies an 83% probability of zero (41%) or one (42%) rate hike in 2016. Our economists expect two hikes this year. The two upcoming FOMC meetings (June 14-15 and July 26-27) and the July Humphrey-Hawkins testimony to the House and Senate will offer opportunities for Chair Yellen to guide the market in the direction of the FOMC central tendency, which also anticipates two hikes in 2016. Put differently, given current futures market pricing we believe more likelihood exists for an incremental hawkish surprise than a dovish surprise.
5. Now-dormant economic growth concerns could awaken at any time and provide a catalyst for a sell-off. Official “total social financing” data shows China credit growth surged by $1 trillion in 1Q but acceleration in credit creation is needed to prevent a slowdown in activity by 3Q (see Asia Economics Analyst, May 3, 2016). Decelerating growth in China would cause investors to re-focus on the prospect of a US recession, a topic that has receded from client conversations after dominating discussions in 1Q. Our US-MAP index of economic data surprises has slipped back into negative territory and reinforces the risk of a slowdown (see page 20). The UK “Brexit” referendum on June 23 represents another imported economic risk.
6. The US presidential election is now part of every client conversation. The closeness of the race appears to be underpriced by the market given polls in prior presidential elections tightened as voting day approached. History shows that during a typical presidential election year, the S&P 500 index remains relatively range-bound until November (see Exhibit 4). But thus far 2016 has hardly followed a regular election playbook. The upcoming party conventions (Republicans on July 18-21 and Democrats on July 25-28) will almost assuredly raise political uncertainty and weigh on equity valuations.
So fade Goldman again, or assume that after a series of abysmally incorrect calls in the past year it will finally be right? We let readers decide.
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