As we reported over the weekend, Goldman’s clients are scratching their heads. As David Kostin explained their confusion, “investors are struggling to reconcile how extreme valuations of both assets can co-exist. It is counterintuitive, but the yield gap relationship between stocks and bonds is currently consistent with the past decade average. Equity risk premium (ERP) is not static and could shift from either direction. “Risk-on” has been the clear mantra since the post-Brexit low. But sentiment can reverse quickly.”
Confused or not they are BTFDing, and Goldman was surprised by their bullishness of its clients, who argue that “sustained low rates will support P/E multiples of 20x or more. The Fed Model relates the earnings yield (5.7%) to the Treasury yield (1.5%). The current 420 bp yield gap is near the 10-year average. Exhibit 2 shows the sensitivity of this model. Assuming a steady bond yield, reversion to the 35-year average gap of 250 bp implies a S&P 500 year-end level of 3075 while the 5-year average gap implies 1900.”
As a result, Goldman found itself in the confusing position of being far more bearish than its clients, predicting that the S&P will rise less than 150 points over the next two and a half years…
… and has to explain the reasons behind its bearishness, as well as the reason why it expects a sharp 5-10% drawdown in the S&P in the coming months.
So, to justify its bearishness, Goldman has released the following list of five items why it thinks that the Fed Model cited by its clients as a bullish signal, will not lead to the kind of multiple expansion that justifies an S&P at over 3,000.
- Valuations are already at historical extremes. The S&P 500 trades at a forward P/E of 17.6x, ranking in the 89th percentile since 1976. At 18.4x, the median constituent ranks in the 99th percentile. Most other metrics such as P/B, EV/EBITDA, and EV/Sales paint a similar picture. These valuations are only justifiable because of the historically low interest rate environment.
- Zero profit growth is not consistent with high stock valuations. Sluggish global growth and low inflation along with negative interest rate policies in Europe and Asia have led to record low US bond yields. Consistent with this backdrop, 2Q results will show the seventh consecutive quarter of declining year/year operating EPS (-3%, but +1% ex-Energy). Despite near-record margins, adjusted S&P 500 EPS have been flat for three straight years.
- Many Financials will have lower profits if low interest rates persist. Historically low yields squeeze the net interest income of banks and make liabilities harder to meet for insurance companies. Our Bank equity research team this week cut their EPS forecasts by 5%-7%. The fall in Treasury yields explains most of the cut. For the aggregate S&P 500, a 50 bp drop in the 10- year yield cuts EPS by $0.25. The headwind consists of a $0.50/share cut to Financials sector EPS partially offset by a boost to the rest of the index.
- Low rates will also detract from earnings by increasing the value of current pension liabilities through lower discount rates. The impact of pensions on S&P 500 earnings was last felt in 2012, when the pensions of three firms – T, VZ, and UPS – combined to subtract nearly $2 from S&P 500 EPS at the end of the year. We estimate that pensions could cause a $2 hit on S&P 500 operating EPS this year if rates remain low. Although many analysts and investors will “look through” these charges, they are yet another wedge in the growing rift between GAAP and non-GAAP EPS.
- The fall in US unemployment hints at wage inflation. The GS wage tracker is now at 2.9%. Higher labor costs suggests lower margins and equity valuations. As inflation expectations climb, the risk exists that the Fed tightens sooner than the market expects and bond yields may also rise. Higher bond yields and a narrowing ERP are consistent with our 2100 target.
Of course, Goldman could have saved itself all the trouble and used just one word: “Japan.” But maybe this time it really is different.
The post With The S&P 140 Points From Its 2018 Year End Target, Goldman Is Confused appeared first on crude-oil.top.