After 40+ days of the S&P going virtually nowhere on muted volume, cross-asset correlations soaring to all time highs, and quant funds leveraging to record levels, it all just snapped on Friday the “volatility on the sidelines” finally made a grand entrance right back into the market, which tumbled the most since Brexit, and closed below its 2015 highs.
And now the question is whether this violent selloff, the fouth such elevator drop lower in the past two years, is over or if it will continue. While there have been several conflicting viewpoints, here we present the opinion of Goldman’s David Kostin, according to whom the selling is only just starting.
To be sure, not even Goldman is willing to go out on a limb as warning a crash is imminent, which is why it prefaces its forecast by saying that “strategically, we expect modest appreciation in the US equity market during the next several years. The domestic economy is growing, albeit at a muted pace of just 1.5% in 2016 and 2% in 2017. Sales and earnings for most firms will increase although margin expansion will be limited. Rising profits should support higher share prices even as P/E multiples contract.”
However, it then just as quickly notes that “tactically, there are five reasons the S&P 500 will fall by year-end 2016.“
So, without further ado, here are Goldman’s five reasons why the market will continue falling from here.
- First, our Sentiment Indicator shows an extreme bullish reading of 95, which suggests the S&P 500 index will fall by 2% during the next month. For context, on June 28 our Sentiment Indicator showed maximum bearishness with a reading of 0 which implied the market would rise by 4% during the following month. During the nine weeks of 3Q our Sentiment Indicator has climbed from 0 to 100 and the index has appreciated by 4%. Readings above 90 and below 10 are statistically significant trading signals.
- Second, we anticipate a rise in political uncertainty, which will translate into a lower P/E multiple. The first of three scheduled Presidential debates will occur on September 26 followed by debates on October 9 and October 19. Although prediction markets assign a roughly 70% probability that Hillary Clinton will capture the White House, the polls have recently tightened and equity uncertainty typically rises ahead of an election (see Exhibit 2).
- Third, recent US economic data has been disappointing. The labor report, retail sales, and both the ISM manufacturing and non-manufacturing surveys were below consensus expectations. The US MAP score of economic surprises is now negative for the first time in two months. The Goldman Sachs Current Activity Indicator (CAI), a real-time measure of the pace of domestic economic growth, is now just 0.9%.
- Fourth, the weak macro data means downside risk to EPS forecasts. Consensus bottom-up adjusted EPS estimates for 2016 equal $118 but have been unchanged for three consecutive years – the epitome of “fat and flat.” Negative EPS revisions have equaled 0.5% during the past three months (-0.2% excluding Energy). Looking forward, the bottom-up consensus expectation of 7% year/year S&P 500 EPS growth in 4Q seems aggressive given it assumes Financials EPS surges by 14%. A patient Fed with rates on hold represents a headwind for the sector where ROE is now below 10%.
- Fifth, equity valuation remains extended. The S&P 500 index trades at the 84th percentile of historical valuation while the median stock is at the 98th.
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It goes without saying that if there was anything that would unelash a major algo-driven buying scramble on Monday – aside from the now usual central bank intervention – it is 5 reasons from Goldman why stocks will continue plunging.