When it comes to the most influential investment bank in the world, Goldman Sachs, its 2018 outlook is borderline euphoric despite the bank’s own explicit admission that valuations have never been higher. In a tortured, goalseeked analysis which we discussed last week, the bank’s chief equity strategist David Kostin said that he expects a year of “rational exuberance” catalyzed by the Trump tax cuts becoming law (some time in early 2018), leading to an upward revised year-end S&P price target of 2,850 (from 2,500 previously) and rising to 3,100 by 2020 (Kostin’s “irrationally exuberant” parallel universe sees the S&P rising above 5,000 as the equity bubble repeats the events of the late 1990s – more here).
Naturally, the chief strategist concedes that all bets are off should Trump fail to pass tax reform (or even a far less comprehensive corporate tax cut program), and the S&P is likely to tumble to 2,400 from its current all time high level above 2,600 (Kostin did not have a S&P forecast for outer years which does not implement Trump tax cut, suggesting that Goldman’s clients will be extremely disappointed, and angry, should Goldman’s 80% odds of GOP tax reform passing prove just a "little" off ).
What is more interesting, is that even in discussions of the future that do not include Goldman’s assumptions of legislative reform, or its explicit S&P forecasts, the bank is especially sanguine, and does not anticipate a bear market as a result of 2017 being a “goldilocks year” in which the world enjoyed coordinated, synchronized global growth courtesy of over $2 trillion in central bank liquidity injections but without the matching increase in inflation, which coupled with a perverse collapse in global volatility…
… has resulted in US financial conditions that have almost never been easier, and would be more indicative of three rate cuts rather than three rate increases, as has been the case.
As a result, Goldman is confident that, absent a shock, “a bear market is unlikely” despite rising risks. Here is what Goldman expects in terms of the 2018 big picture:
On the negative side, investors can point to the combination of an already mature economic cycle and a long and strong bull market (mainly driven by loose monetary policy). Valuations are also stretched in most equity markets, particularly the US. These factors, combined with the start of (albeit moderate) quantitative tightening (QT) may also be cause for some concern.
On the positive side, investors can be reassured by the strength and durability of the current economic cycle. While it has already been a long cycle, the unwinding of the financial crisis has also meant that, until recently, it has been sub-par in terms of strength – as is often the case following financial crises. This has been the case even in the US, where the recovery has been more robust than elsewhere and has helped to contain inflationary pressures.
Goldman is also quick to explain that since equity bull markets do not die of old age, its own bull/bear market indicator – which as we noted two months ago is at levels that preceded both the dot com and the 2007 global financial crisis – should be largely ignored:
Economic cycles and equity bull markets do not generally die of old age. Our work on bear markets shows that major drawdowns require triggers. The most severe type of bear market – the ‘structural’ bears – are a consequence of the unwinding of major economic imbalances and, typically, a financial bubble. These risks are low currently given that many of the pre-crisis imbalances have been reduced or shifted to the official sector and to central banks. Meanwhile, ‘cyclical’ bear markets are a function of the economic cycle and are nearly always triggered by a tightening of monetary policy in response to inflation pressure. While our bull/bear market indicator (Exhibit 6) is at elevated levels, this mainly reflects the strength of the current economic cycle, low unemployment and high valuations. Importantly, two of the other factors that are included in this indicator are not at elevated levels. Inflation is low and stable and, as a consequence, the yield curve remains upward-sloping. Without higher inflation, it is unlikely that we have the conditions for a recession and, therefore, a bear market.
So while the Goldman “base” case”, which also happens to be the optimistic return scenario in which the S&P rises another 250 points, or roughly 10%, over the next 12 months (paradoxically resulting in a PE that is roughly 20x even as the Fed hikes rates another 4 times, in the process likely inverting the yield curve, and central banks collectively slowing the annual pace of liquidity injections by $1 trillion) is clear, the above bolded text lays out what Blankfein’s strategists see as the biggest threat to their scenarios for the coming year: inflation.
But besides rising inflation and/or inflation expectations, Goldman sees two other risks to its otherwise “rationally euphoric” outlook for the coming year. In sum, Goldman believes these are the three biggest risks to stocks in the coming year:
- A bull squeeze.
- A short correction.
- A rise in inflation expectations.
Addressing the first point, also perhaps known as the “crack up boom", or market melt-up case, Goldman’s European strategist Peter Oppenheimer writes that the bank has “heard frequently from clients in recent time about the lack of an exuberant surge in stock prices that is so often synonymous with market peaks.” He notes that investors fear that they could be left behind in the last ditch “surge of optimism as interest rates stay low and growth expectations continue to build and are further boosted by US tax reform.” To this Oppenheimer counters that “there are plenty of factors, particularly valuation, to suggest a market fall is more likely.” He makes the point by showing that we have now seen the second-longest period since 1929, at least for the S&P 500, of returns without a correction of 5% or more.
Yet even in admitting that a correction (or bear market) is long overdue, Goldman’s advice to clients is simple: don’t sell, to wit:
Even with risks of a correction or bear market, we think the best action is to stay fully invested, as we have found that anticipating market peaks by selling the market too early can be very ‘expensive’ in terms of forgone returns. For example, on average an investor who sells equities just 3 months prior to a peak (in the US) misses a 7% rise in prices; this is around the same amount as an investor who remains fully invested would lose in the first 3 months of a bear market.
Naturally, the above assumes a garden variety correction, and not some of the cataclysmic market corrections predicted by the likes of Fasanara Capital, Marko Kolanovic and others (such as this website), who anticipate a historic collapse, one which could lead to a comprehensive and indefinite market shut down as liquidity is drained in a post central banker backstop world. Goldman then makes a more relevant point, namely that any initial crash will likely see a sharp rebound in the early days of the bear market:
We also find that nearly all bear markets start with a correction, followed by a powerful bounce that offers investors an opportunity to sell later, assuming of course that they recognise this is an opportunity to sell rather than buy.
Here, too a caveat is warranted: the “powerful bounce” envisioned by Goldman is the result of shorts rushing to cover their positions and providing a natural downside buffer to the market. This may well not happen during the next bear market as Goldman itself showed that short positions among the hedge fund community are approaching record low levels, as the market’s relentless grind higher over the past year has crushed all but the most dedicated bears.
This brings us to the next risk, inflation, and as Goldman suggests, “for a correction to turn into something more sustained – a deeper and longer bear market –think inflation needs to rise, pushing up interest rates and increasing the risks of recession."
As Exhibit 23 shows, there is a very substantial divide between inflation measured in the real economy (consumer prices, wages and commodity prices) since the start of QE in 2009 and inflation in asset prices. Anything that pushes up inflation is likely to result in higher rates. In our central case this is likely to moderate inflation in financial assets (prevent valuations from rising), while in a more extreme case, if inflation rises too sharply interest rates would also need to ‘normalise’ more radically than current markets imply.
The chart Goldman refers to is also the one we showed two months ago when a very confused Janet Yellen said the Fed no longer appears to have a grasp on “low inflation.” As Goldman, and we, showed, inflation is only low in the real economy. In the financial economy, measured by asset prices, inflation has never been higher.
To be sure, Goldman’s point is valid: if and when inflation seeps out of asset prices and into real economy prices, perhaps as the velocity of money undergoes an unexpected spike (for reasons still unknown) ultimately leading to a sharp rise in wages, the Fed will be forced to catch up aggressively by tightening monetary conditions far more than the Fed (via the dots) or certainly the market anticipates currently. This, however, brings a scary tangent: on Saturday, Citi’s Hans Lorenzen speculated that the Fed may be paralyzed even in the face of runaway “real world” inflation, as at least “some central bankers Citi has spoken to” admit they are afraid they have lost control over the market and its “reaction function” expectations. This is the world that result in hyperinflation in both the real and financial economies, and potentially culminates with the collapse of both fiat money and conventional monetary economics, unleashing the next global financial crisis as previewed recently by Deutshce Bank’s Jim Reid, and to a similar extent, JPM’s Marco Kolanovic.
Yet in its attempt to avoid a client panic and preempt selling, Goldman comes up with an ingenious loophole: yes, the stock market may crash as it has never been more overvalued, but if it does, it will drag down all other asset prices with it, unleashing a catastrophic liquidation waterfall across all markets. To wit:
In an environment where higher inflation expectations push up bond term premia, we would expect a correction across asset markets. While equity markets are expensive relative to history, so are most asset classes (Exhibit 24 and 25), which means they all are vulnerable to falling together, leaving few places to hide.
And there it is: Goldman admits markets have never been more overvalued, Goldman concedes that the market is long overdue for a correction if not bear market crash (something SocGen had the temerity last week to suggest will happen in 2018), it warns that should Trump’s tax reform not pass the market will tumble, it cautions that if inflation finally does pick up – which ironically is precisely the Fed’s goal in its attempt to inflate away the world’s record debt load – equities will likely crash… but here’s the punchline: don’t sell because just where are you going to put your money, or as Oppenheimer puts it, “equity markets are expensive relative to history, so are most asset classes which means they all are vulnerable to falling together, leaving few places to hide.”
As a result, according to Goldman’s “logic”, it is not even worth bothering hiding. Well, there is one alternative:
For multi-asset investors, holding cash as a hedge against an overweight equity position remains a favoured strategy as an inflation-led bear market in equities would affect most financial assets, leaving few places to hide.
Or maybe not cash: judging by the meteoric rise in digital currencies, not only do traders disagree with Goldman’s unique brand of “logic”, but it is increasingly cryptocurrencies – and not cash – that is seen as the hedge to a systemic crash which could take down the very fiat monetary system that created it in the first place.