The Seven Questions Goldman"s Clients Have About "Rational Exuberance"

In mid-November, just days after Barclays released its 2018 equity outlook with the title "Rational Exuberance"...

... Goldman"s David Kostin decided that imitation was the sincerest form of unveiling a non-contrarian year-end forecast, and in presenting his revised S&P price target for 2018 of 2,850 - which accounts for GOP tax reform - "borrowed" the Barclays title for his own year ahead preview...

... despite admitting that valuations have never been higher, thus suggesting that contrary to the title, the exuberance is anything but rational.

To be sure, despite their hyperbolic titles, both Barclays and Goldman simply went with the sellside flow: in fact, in addition to Barclays and Goldman, Wall Street strategists polled by Barron"s said they expect about a 7% S&P gain for 2018 same as basically every single year, according to Sentiment Trader who points out that "they"re not stupid, they go with the base rate." Indeed, there is power in numbers, because if everyone is wrong about the year ahead, it is the same as nobody being wrong, something Wall Street discovered in 2007.

And yet, with not one but two banks mangling Alan Greenspan"s infamous words to justify their late cycle bullish outlook which both admit is not deserved on a fundamental basis, Goldman"s clients remain confused, and in his Weekly Kickstart, Goldman"s chief equity strategjst David Kostin writes that he has spent the last two weeks meeting with investors to discuss his outlook for US equities in 2018, including the impact of tax reform.

"Our Nov. 21 report, entitled Rational Exuberance, describes our expectation that 14% EPS growth, driven by healthy economic growth and a 5% boost from tax reform, will lift the S&P 500 index to 2850 by year-end 2018 (+8%)."

While it will hardly come as a surprise, Kostin confirms that as we reported last week most investors remain exceptionally bullish despite the all time high in the S&P and despite record valuations, instead betting that the Fed will always step in to keep the upward mometum in risk assets; still while "most clients agree with our bullish sentiment but they questioned several of our specific views."

Below Kostin addresses seven of the most common investor questions prompted by his forecast, or specifically the things Goldman"s clients think is irrational about "rational exuberance.":

1. How can you be “rationally exuberant” about the path of US stocks in 2018 when equity valuations are so high? Although the median S&P 500 stock trades in the 99th historical valuation percentile, valuations are typically poor indicators of short-term returns. Moreover, in contrast to the “irrationally exuberant” market of the late 1990s, today’s equity valuations are justified by a macro environment of extremely low rates, modest inflation, high corporate profitability, and a stable economy. Nonetheless, earnings growth, rather than higher valuation, drives our 2018 forecast. 

 

 

2. If the out-of-consensus US Economics forecast for the Treasury yield curve is wrong and rates stay low in 2018, could equity valuations rise further? The “melt-up” scenario of a forward P/E that rises to 19x or 20x is possible, but unlikely. Our forecast for a stable 18x forward P/E multiple at year-end 2018 assumes the economic expansion continues, ROE rises, and the equity risk premium (ERP) narrows. However, in contrast with market pricing (2 hikes) and almost every client we have met (2 or 3 hikes), our economists expect the Fed will raise rates four times next year as the labor market tightens and inflation firms. A rising term premium should lift the 10-year Treasury yield to 3.0% and restrain further P/E multiple expansion.

 

3. Why did you downgrade the Information Technology sector when it has twice the sales growth and twice the margins of the rest of the S&P 500? The Tech sector’s low effective tax rate (19% vs. 26% for the S&P 500) means it has little to gain from tax reform. Recent performance supports our view. Regulatory risk is another reason for our downgrade. However, we recommend a Neutral weight (24%) in the sector due to strong fundamentals. Investors with sufficiently long investment horizons may find policy-driven weakness an opportunity to add to positions in the sector’s strongest secular growth constituents, which we believe remain attractive. We recommend overweight positions in Financials and Industrials. Both sectors pay above-average effective tax rates and are likely beneficiaries of tax reform. In addition, each sector has fundamental tailwinds such as deregulation and rising capex spending that should boost earnings in 2018.

 

4. Following value stock outperformance during recent weeks, do you still recommend growth as a style in 2018? Concentrated positioning and correlation with the Technology sector are clearly short-term headwinds to growth stocks. In fact, the  acceleration in already-strong US economic activity should have led value stocks to perform even better than they have during the past several months (Exhibit 2). However, our economists’ forecast of 2.5% US GDP growth in 2018 portrays an economic environment typically conducive to growth stock outperformance and suggests that our sector-neutral growth factor should fare well during the course of the year.

 

 

5. Is the equity market already pricing the full impact of tax reform? The prediction market shows roughly 80% odds of passage. Equity market indicators such as Altaba (AABA) and our High Tax Rate basket (GSTHHTAX) send broadly similar signals. However, lingering uncertainty regarding both the provisions that will be included in the final legislation as well as the potential impact of several proposals, such as limiting interest deductibility and the treatment of cross-border transactions, suggest more rotation at the industry and stock levels remains in store.

 

 

6. What does the Senate proposal to delay the tax rate cut until 2019 mean for S&P 500 earnings and performance? The delay in rate cut until 2019 will save roughly $140 billion in government revenue but weigh on 2018 EPS as firms face several base-broadening provisions without the offsetting benefit of the rate cut. However, we expect the net 5% boost to future earnings will be unaffected, as would our 2019 EPS estimate of $158. The likelihood that companies pull forward capex and other expenses into the higher-tax year of 2018 may even boost economic activity and provide a net 2019 earnings benefit to S&P 500 companies beyond our current f orecast. In total, particularly against a backdrop of low discount rates, we expect little impact on stock performance from a potential delay in tax cut.

 

7. How big a risk to EPS is the Senate’s proposal to limit interest deductibility at 30% of EBIT? The proposal would have a minor impact on S&P 500 firms but pose a greater risk to more highly-levered small-caps. Consensus 2018 estimates show 5% of S&P 500 constituents but 15% of the Russell 2000 paying interest expense above 30% of EBIT. However, the proposal suggests incremental downside risk to buybacks and credit issuance as companies adjust corporate structures in response. In addition, the pro-cyclical proposal would have a much greater potential effect on US firms in environments of higher rates or weaker earnings; the current ratio of S&P 500 interest expense to EBIT is nearly the lowest in at least 35 years.

 

Finally, for those who have missed the barrage of year-ahead outlooks from Goldman in the past two weeks, here is a summary of what the world"s most influential bank believes will happen in the next 12 months: "We forecast the S&P 500 index will rise by 8% to 2850 by year-end 2018. EPS will benefit from tax reform and climb by 14% to $150 while the forward P/E multiple remains stable near 18x. Growth style will prevail over value and Industrials and Financials will outperform while Consumer stocks lag. Thematically, we prefer firms that prioritize investing for growth via capex and R&D. Most clients agree with our bullish sentiment but they questioned several of our specific views. Investors have a less hawkish view than Goldman Sachs economics on the bear flattening of the yield curve and implications for equity valuation and continue to focus on the implications of tax reform."

Junk Bond Debt Covenant Quality Drops To All Time Lows

By Mark Rzepczynski of the Disciplined Systematic Global Macro Views blog

Corporate spreads are tight and there is little room for further reduction given the absolute level of spreads.

The reach for yield may be at an extreme. The bond spread is the compensation given bondholders for taking on the risk of corporate debt; consequently, it should become a concern when the quality of bond covenants or protections declines with spreads. Of course, if risk is declining, this is not the case, but at this point in the credit cycle it is hard to make that argument. An inverse relationship between spreads and covenant weakness means you are getting less compensation and less protection for the same risk, all things equal.

The Moody"s Covenant Quality score was developed to measure the change in bond structuring terms that will be detrimental to bond investor. It moves between 1 and 5 with 5 being the weakest covenant quality. It is now at all time lows.

There may be reasons for corporate debt risk to fall. Rates are low, so refinancing is cheap. Demand for credit is still high and debt to equity levels are manageable for many sectors. However, forward expectations suggest that return versus risk is less attractive from a structural perspective as bond covenants are loosened. Hence, opportunities should be found elsewhere.

An alternative is to exit the credit markets and hold liquid portfolio of dynamic beta bets through global macro and managed futures. Generally, managed futures traders do not take credit risk, so the return profile will be based on other risk premium such as momentum. A swap from tight risk premiums to those that may be less cycle dependent can improve the risk exposure of a portfolio.

The Cost Of Market Crash Insurance Just Hit A Record High

With the VIX surging, and then quickly getting pummeled on two occasions in the past three weeks, dizzy traders could be forgiven to assume that any latent "risk off" threat, whether from North Korea or the US political front, has been taken off the table. However, a deeper look inside the vol surface reveals something very different: with increasingly more analysts and traders warning that volatility is set for a sharp return this fall, equities have already been adjusting to the increased probability of a "tail event." However, instead of buying VIX futures, call or ETPs, they have been doing so by bidding up the price of OTM equity put options, or equivalently, by steepening the S&P 500 put skew and.

As a reminder, a put skew shows how much more expensive it is to buy deep OTM puts vs puts that are in the money or in other words, a levered bet on (or hedge against) a market crash.

 And as the following chart from Bank of America shows, the S&P put skew is now at the highest level on record, making the relative price of tail hedges the highest in 13 years as traders are quietly bracing for a sharp market crash.

While not new, Bank of America again underscored the potential risk in the coming months to actively managed portfolios from a possible volatility flaring event, primarily impacting risk-parity portfolios. This is what the team of BofA Benjamin Bowler wrote in an overnight note:

Both equity and bond valuations are high. In a report from last week, our equity strategists pointed out that the S&P 500 forward P/E expanded in July and hit its loftiest level since the Tech Bubble. Even at these elevated levels, equities look attractive relative to bonds whose risk premium is more than 50% above its long-term average. This is clearly a concern for portfolios that invest in both classes (risk parity). A significant risk for multi-asset managers going forward is a breakdown in the diversification between stocks and bonds in which we see simultaneous declines in both asset classes similar to the ‘Taper Tantrum’ in May/Jun-13 or to a slightly lesser extent the risk-off event from Aug-15 two years ago. It may be surprising to an equity investor, but for a multi-asset manager these two declines were the largest since 2008 and equal to 50% of the drawdowns from the GFC. With multi-asset vol so low, for those managers who use leverage, the leverage levels may be high and therefore their portfolios may be more sensitive to a breakdown in correlation.

Bank of America then writes that with both rates and equity volatility at historically low levels, however with correlations between the two rising, going into the fall - even if equities and rates remain range-bound - an uptick in volatility could lead to outsized jumps in a cross-asset vol pair trade.

Interestingly, for most of this year an increase in equity volatility has tended to coincide with an increase of rates volatility. The payout is dependent on rates going higher and equities falling from current levels, so it is implicitly short equity/rates correlation. This correlation has had an increase over the past month and provides for an attractive entry point (Chart 11)."

Indeed, while many traders point out that intra-equity correlation has dropped to near all time lows, traditionally a welcome sign for active investors as it provides return dispersion and alpha creation abilities that are detached from broader macro conditions, looking at cross-asset vol shows a very different picture. As the following two charts show, correlation between rates and equity volatility, or MOVE and VIX, shows a sharp spike in recent weeks. In fact, as Chart 10 shows, the correlation is now the third highest on record. Confirming this troubling observation, Chart 11 shows that the correlation between the underlying asset classes has also soared in recent weeks, after plumbing near record lows just weeks ago.

To explain the surge in put skew, below we present several observations from BofA on why the recent period of record low volatility appears to be coming to an abrupt end.

1. The S&P recorded three moves of at least +/- 1% within a six days span, the first time this has occurred since September 2016. In fact, prior to the 1.48% loss on 10-Aug, SPX hasn’t moved morethan +/- 0.3% in a single day since 19-Jul.

"These larger one-day moves are evidence that the record-low vol we’ve seen throughout the summer may be starting to come to an end. As we’ve noted recently, seasonal trends and a fall which encompasses numerous catalysts (including the debt ceiling deadline, the September FOMC meeting, and political reform negotiations) suggest that the extreme quiet may not last much longer."

2. Last week, the VIX recorded +30% spikes twice in a six day period (10-Aug, when the VIX jumped 44.37% and 17-Aug, when the VIX jumped 32.45%). This is only the third time ever that we’ve seen two such drastic moves occur in that short a period of time.

"Notably, the only other two times this has occurred were early August 2011, immediately following S&P’s downgrade of US government debt, and August 2015, when markets were rattled over fear of slowing growth in China. The seasonally low vol environment typically seen during late summer may be a contributing factor to these occurrences as each has happened during August."

3. On 8-Aug-17, the total number of VIX call options (including all strikes and all expiration dates) was 1,994,418, an all-time high, as investors piled into long call options amid the rising tensions with North Korea. The amount of options traded surpassed other notable highs on 3-Feb-2014 and 13-July-2015, when 1.85mn and 1.93mn call options were traded, respectively. "The former period saw investors buying VIX calls due to a global selloff sparked by concerns over Asia and EM, and the latter period saw purchases on the back of Grexit fears."

4. On 17-Aug SPX fell 1.5%, the second largest decline YTD since the 17-May 1.8% drop and similar to the 1.4% sell-off on 10- Aug. However, in one regard this sell-off was remarkably different.

"Specifically, markets this time around appeared to have made little distinction between different pockets of the market. For instance, the underperformance of cyclical sectors vs. defensives was less pronounced in the latest sell-off. Consequently, also the relative moves in volatility were not as significant as in the past two largest sell-offs YTD. This could signal the beginning of a new narrative whereby market participants are more skeptical about the prospective of a pro-business agenda being pushed forward in Washington; as such they stop differentiating between potential losers and winners from the aforementioned agenda."

French Bond Investors Skeptical That Election Risk Is Over

Bond investors are far from convinced that the risks surrounding the French election are over despite the broader market exuberance following the outcome of the first round.

French 2Y yields have only corrected about half of the risk premium over German 2Y yields since the election (and in fact are widening out today)

Furthermore, as Bloomberg details, open interest, a measure of the number of contracts outstanding, has dropped only 10 percent so far this week even as French government bond futures surged after the race for presidency narrowed to Emmanuel Macron and Marine Le Pen.

A decline in open interest amid a rally in an asset typically suggests short-covering rather than new positions being added... but the modest size of the drop suggests few investors are relieved enough to pile back into "still cheap" OATs.

"All Clear"? European 'VIX' Crashes By Most Ever To Record Low

With the Dutch Election behind them, it appears European stock investors see nothing but smooth-sailing ahead...

Europe"s VIX collapsed overnight - by the biggest relative amount in its history - to close at the lowest level since the Euro began...

For context, this collapse compressed the relative risk premium for European stocks over US stocks to zero... something we have only seen historically at extreme systemic stress points...

So the "all-clear" seems to have been given - don"t worry about French elections, the rise of AfD in Germany, Turkish tensions, the ECB on the verge of tightening, and peripheral bond risks rising... just dump your hedges.

"Bucket Economics" For Global Macro Investing

By Chris at www.CapitalistExploits.at

I was recently sent a research piece by one of my LPs.

The piece was from the principal of a well known hedge fund and this particular manager has grave concerns for the US stock market. In the article to clients he laid out all the reasons why fundamentally none of it makes much sense. I can"t and won"t disagree with the primary analysis.

He"s not the only one.

Many of my friends and colleagues in this industry are saying similar things. In fact, quite a few of my friends and LP"s have asked, "Why are you not short?"

A very good question I"ll try explain by way of "Bucket Economics" (trademarked). Distinctly different to "Fu**it Economics", which is what you get when you get it all wrong.

Reasons to Be Bearish the US Equity Market

https://twitter.com/jtepper2/status/828599652694032385

Geez...

And this from John Hussman at Hussman Funds:

https://twitter.com/hussmanjp/status/825752513508958208

These are all sharp smart investors and I"ve taken just two as a sampling, and they"re clearly bearish.

While this is taking place in the land of apple pie across the pond we have...

A Spanner in the Works

Here we see France"s risk premium rising. Franco-German bond spreads blow out as the market attempts to come to terms when Le Pen unveiled her party"s manifesto (see my article earlier this week on this very topic).

I"ve written about the problems in Europe till my fingers bleed so I"ll not be revisiting it now. Curious or forgetful readers can simply scour the site.

Europe has some serious issues in front of them, not least of which is how the euro breaks up and the multiple ramifications both socially and economically. Not to mention how the bureaucrats in Brussels are going to deal with member states refusing to pay debts.

In a nutshell, Europe looks a lot worse than the US right now. A LOT worse.

Ok, so now let me throw out why I"m unprepared to short the US stock market.

Here"s how I think about it.

Capital typically has 3 places to live.

Think of these as investment buckets, where you will keep your investments in the most favourable bucket or buckets at any one time.

In a stable goldilocks economy where inflation is neither to high nor too low, where debt is low and manageable, and where faith in currency is not in question we could argue that investors would be OK with the above setup (not trying to be too fancy - bear with me).

What about when inflation is rising sharply? How do investors re-allocate?

Simplistically, like this:

How about a strong deflationary environment?

Simplistically like this:

Now, let me ask you to consider that as investors we have the entire world in front of us into which we can allocate our investment capital.

One thing I"ve learned over the last 20 odd years in finance is that capital flows are extremely important and have become increasingly important as globalisation has taken hold. As such, it"s not just equities but equities in what country. Ditto bonds and currencies.

The ease and speed with which we can allocate capital not only into multiple sectors, but into multiple currencies and indeed countries means that not only do the above buckets apply to the 3 categories listed but they apply to countries and currencies of countries. So cash, for example, can be USD, JPY, EUR, RUB, CNY, and a whole range of others, or a basket of them.

So I want to ask you a question:

When allocating capital, imagine for a minute you"re managing a few billion dollars (as I know some of you are). Now let me ask you where you"re going to allocate looking out over the next couple of years?

• Europe? Looks to be on the precipice and uncertainty is rising, not falling


• Emerging markets? Lost $60 billion in December and are typically considered more of a "risk on" trade


• The US?

A blow up in Europe, which looks more and more inevitable with each passing day, will see capital flee to the land of warm apple pie.

This will have to go somewhere, and so much of it will go into treasuries causing the dollar to strengthen and stoke inflationary fears.

Much will head into equities too.

This too will stoke fears of inflation and the clowns Fed who are way behind the curve already will scurry to catch up, raising rates. Ironically, raising rates will further exacerbate the spreads between US and non-US paper causing more capital to head to the US, creating a self perpetuating cycle.

This will actually be highly contractionary for the global economy as it will cause further dollar funding shortages (read my piece on the eurodollar market for more on this topic).

As the rest of the world contracts, the US will seemingly appear to be the only safe place to park capital. More self perpetuating capital influx.

Note that this capital flowing into the US will have nothing to do with US corporate profits and none of this will really have anything to do with policies enacted by the Trump administration (though you can bet your bottom dollar Trump will be sure to take credit for it, misunderstanding what is actually taking place and why).

Aaaand so....

Is the US equity market overvalued? Yes!

Do I want to be short the US equity market? No!

There are many pieces to this puzzle and I don"t pretend to know them all or how they will interact with one another.

What I do know is that global capital flows often overwhelm any "fundamental valuations" (I never used to think like this as for years I was firmly in the fundamental value camp).

I also know is that globally we"ve never before been so inter-connected than we are today.

Furthermore, I do believe that we"re rapidly running out of road down which the can will been kicked. Europe first and the consequences of that favour Trumplandia.

- Chris

"There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen." — Frederic Bastiat

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Italy Bond Risk Soars To 3-Year Highs As Youth Unemployment Tops 40%

The last 4 months have seen something "odd" happen in Europe"s periphery. Sovereign "risk" has conspicuously (and rationally) risen as macro-fundamentals have deteriorated - something that we have not seen since Draghi"s 2012 "whatever it takes" moment.

For the first time since June 2015, Italian youth unemployment has risen above 40% and notably, Italian bond yields are rising...

And the result is growing concerns about Italy"s idiosyncratic risk as the risk premium of BTPs over Bunds soars to its highest sicne 2014 (worst now than the Referendum peak)...

Time for moar "whatever it takes" - just ignore the transitory inflation surge and currency war warnings from Trump.

Goldman "Concerned" As Risk Appetite Index Hits Record High

Speaking at a conference in London, Goldman MD Christian Mueller-Glissmann warned investors, "valuations are at very high levels. And that concerns us when it comes to making progress in stocks, unless you maintain a very high level of optimism." The firm"s aggregate risk appetite index reached record highs in December - the same peak reached in 1999/2000 and 2007... and we know what happened next.

"This is a chart which a lot of people have in the back of their mind right now. It"s our risk appetite indicator. That essentially shows you across asset classes what the risk appetite is. And it has equity risk premium in there it, it has VIX, it has everything that reflects how bullish markets are and it"s real time."

Mueller-Glissman goes on...

"And guess what, in the middle of December, that indicator had the highest level in the history of the indicator. We are not at the beginning of this optimism trade, we"re really in the middle of that optimism trade."

Roughly translated, like small business optimism, this is as good as it gets for markets.

Here"s two examples of that "risk appetite"...