It’s been difficult year for Goldman’s chief equity strategist David Kostin.
On one hand, to your left your have such gloomy analysts as Peter Oppenheimer who two weeks ago said that “things do not look encouraging” as various market signals suggest that “equities could be about to enter a sustained bear market.”
Then, to your right, are “optimistic” economists such as Jan Hatzius, who still expects the Fed to hike 4 times in 2019 in addition to once in December, even as he expects the yield curve to invert in the second half of 2019 and the economy to grind to a crawl, below 2.0% by 2020.
So what do you recommend in your annual equity outlook report when within your own company you have opinions ranging from one extreme to the other, and somehow have to find a way to bridge them?
Well, first you admit that “all good things eventually come to an end” adding cryptically “But when?” Then you launch into some philosophy:
Answering this question represents the fundamental 2019 investment challenge for portfolio managers. For equity investors, risk is high and the margin of safety is low because stock valuations are elevated compared with history. Our baseline assumption is that both economic and profit growth will be positive in 2019 but decelerate from the robust levels of 2018. We forecast the S&P 500 index will generate a modest single-digit absolute return in 2019.
Next, your cover your bases, laying out a future returns matrix that literally covers every possibility:
- Base Case (50% probability): S&P 500 closes 2018 at 2850, and then climbs by 5% to reach 3000 at year-end 2019. We forecast EPS will grow by 6% to $173 in 2019 and by 4% to $181 in 2020. Consensus growth equals 8% and 10%. P/E multiple will remain stable at 16x. Valuation has already declined by 12% YTD.
- Downside Case (30% probability): As 2019 progresses, investors may become increasingly concerned about the risk of a recession in 2020. Earnings estimates are slashed, the P/E contracts to 14x, and S&P 500 ends 2019 at 2500.
- Upside Case (20% probability): Economic growth remains stronger for longer than investors expect. Consensus 2020 EPS estimates are trimmed only slightly and P/E multiple returns to its recent high of 18x. S&P 500 ends 2019 at 3400.
And visually:
Then just in case your clients end up having light and not so light weapons and are vindictive, should everything go to hell next year, you also casually toss in a reco to go long cash: “Mixed asset investors should maintain equity exposure but lift cash
allocations.” The reason – everyone is overweight stocks and underweight cash:
“Households, mutual funds, pension funds, and foreign investors have equity allocations ranking in the 89th percentile vs. history but have cash allocations at just the 1st percentile.”
As a result, “Cash will represent a competitive asset class to stocks for the first time in many years.”
You justify this downside case by forecasting that while equities will post a higher 2019 absolute total return (7%) than cash (T-Bills, 3%) cash will outperform the projected return on 10-year US Treasuries (1%). Of course, what this means is that Treasuries will likely outperform everything, while cash is flat and stocks tumble.
However to avoid disappointing your bullish clients, which for Goldman is the majority, you leave off on a positive note, saying that you “expect the current bull market in US equities will continue in 2019.”
Our baseline forecast is the S&P 500 index closes 2018 at 2850, and then climbs by 5% next year to reach 3000 at year-end 2019. The 2019 total return including dividends will equal 7%. Consensus bottom-up EPS estimates will decline by 4% from current levels and the forward P/E multiple will remain stable at 16x. Valuation has already declined by 12% since the start of 2018. Put simply, stocks have already started to price in the risk of an economic slowdown.
Finally, even as Kostin expects the bull market to continue, the Goldman strategist tells its clients to “increase portfolio defensiveness” and go overweight Info Tech, Communication Services, and Utilities, while Underweighting Cyclicals.
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