There is little joy for bulls in David Kostin’s latest weekly kickstart, in which the chief Goldman strategist says that “the S&P 500 has reached our 2016 year-end target of 2100. We expect that the index will remain at this level given tepid US GDP growth, a mixed earnings outlook, and elevated valuation. Corporate repurchases are the main source of US equity demand. We forecast S&P 500 gross buybacks will rise by 7% to $600 billion in 2016. S&P 500 cash M&A spending surged 116% last year but we forecast a 40% decline in 2016 to $240 billion, reflecting increased regulatory scrutiny, new tax policies, and political and policy uncertainty.”
With that rather gloomy forecast out of the way, Goldman then goes on to list the four most pressing questions troubling its clients as of this moment, starting with “Where to from here?” As Kostin writes, this “is the question we receive most frequently from investors now that the S&P 500 has reached our year-end 2016 target. After an 11% plunge to start the year, US equities have rebounded by 14% and have now posted a 2% gain YTD. We maintain our forecast that S&P 500 will end the year at 2100, unchanged from the current level.”
Broad “big picture” questions aside, here are the four things Goldman’s clients would like answered asap.
1. Why will US stocks post a flat return through year-end? Mediocre economic growth, a mixed earnings outlook, and high valuation will limit further appreciation. (a) The US economy is growing, albeit at a tepid pace. Our colleagues in US Economics research estimate US GDP growth will average 1.8% in 2016. Weak end demand implies low sales growth and profit margins have been stagnant for the past five years. (b) The earnings outlook is cloudy because, although operating EPS will rise by 9% to $110 per share, adjusted EPS will be flat for the third consecutive year. Negative EPS revisions are likely during the course of the year. (c) Valuation is stretched given the S&P 500 index trades at the 86th percentile of long-term historical valuation based on seven metrics: P/E, EV/sales, EV/EBITDA, PEG ratio, free cash flow yield, cyclically-adjusted P/E, and P/B. Moreover, the median stock in the S&P 500 trades at the 96th percentile of historical valuation.
2. How much do buybacks contribute to the overall demand for shares? Corporate repurchases (net of share issuance) are the main source of net demand for US stocks. We forecast households, foreign investors, and pension funds will all be net sellers of US stocks in 2016.
Our recent report Flow of Funds: Buybacks drive demand, foreigners retreat (April 14, 2016) analyzed the supply and demand for shares and updated our forecasts. Corporate demand for US equities equaled $561 billion in 2015, a 40% jump from the prior year and the second-highest level since 1952 (2007 totaled $721 billion). In contrast, foreign investors sold $103 billion of US stocks in 2015, the lowest level of annual demand in 64 years. China, Canada, and the Middle East were the main drivers of overall foreign outflows. The surface appearance of $47 billion of mutual fund equity purchases was a mirage because most of these inflows were directed to non-US equity funds.
We forecast S&P 500 gross buybacks will rise by 7% to $600 billion in 2016 and account for roughly 27% of total capital usage. With the US economy growing at a modest pace and capacity utilization at 75%, below the long-term average of 80%, we forecast overall S&P 500 capex will rise by just 1% as Energy spending falls sharply.
Buyback authorizations declined by 53% YTD (as of April 18) compared with the same period last year ($122 billion vs. $257 billion). One explanation for the sharp drop is that last year several firms announced large, multi-year buyback programs that they intend to execute over time. For example, AAPL and GE both announced $50 billion buyback programs in April 2015. While AAPL has roughly 60% of its buyback remaining, GE still has 93% of its program left to complete. Similarly, WMT announced a $20 billion buyback authorization last year and has an estimated 88% remaining. Our buyback desk estimates that approximately $210 billion of unused authorizations are available for execution as of the end of 1Q 2016.
3. What is the prospect for cash M&A spending by S&P 500 firms? We cut our 2016 S&P 500 cash M&A spending forecast to $240 billion (from $300 billion) reflecting a 40% drop from 2015 total of $400 billion. Cash M&A spending soared by 116% last year so our reduced forecast for 2016 reflects a 30% increase from the 2014 level. In terms of overall spending, announced US M&A transactions fell by 38% on a year/year basis in 1Q. We believe regulatory scrutiny, new tax policies, and political and policy uncertainty in the US, Europe, and Asia will constrain M&A spending growth this year.
4. What investment strategies will generate outperformance in a flat market environment? We expect stocks with above-average dividend yield and growth will beat the flat S&P 500 return we predict over the next eight months. Our sector-neutral basket of 50 stocks (GSTHDIVG) has higher yield (2.7% vs. 2.1%), faster expected dividend growth over the next two years (12% vs. 6%) and a substantially lower P/E multiple (14.7x vs. 17.6x) than the S&P 500. The basket has returned 4% YTD compared with 3% for S&P 500.
And to think that just until a few weeks ago Goldman was on the value-growth un-rotation bandwagon, and was urgently pushing companies with “strong balance sheets” to clients. Somehow we doubt we are going to hear that reco for a while.
One other thing we certainly won’t hear about, is Goldman’s Hedge Fund VIP basket, which until recently was going to be made into an ETF. We are guessing those plans are put on hold?
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