In her just released forecast for 2019, BofA equity strategist Savita Subramanian echoed what Goldman said yesterday, when it advised its clients to “lift cash allocations“, with Subramanian stating that TINAA – or There Is Now An Alternative – is the new TINA.
Specifically, the BofA strategist writes that for much of this cycle, the “TINA” argument (“There is no alternative”) held for stocks: bonds’ elevated rate risk and zero-yielding cash allowed stocks to handily win the asset class beauty contest. But cash is now competitive and will likely grow more so (assuming the Fed keeps hiking which is increasingly in doubt).
BofA calculates that cash yields today are higher than the dividend yield for 60% of S&P 500 stocks, and the bank’s Fed call which sees the Fed continuing to hike for much of 2019, puts short rates close to 3.5% by the end of 2019, well above the S&P 500’s 1.9% dividend yield.
What does this mean for stocks? Here Subramanian writes that she expects equities to peak next year, but bearish positioning and weak sentiment in stocks present upside, especially if trade risks subside.
As a result, Subramanian expects upside to equities through year-end and into next year and thus maintains its 2018 year-end target outlook for 3000 on the S&P 500 as a result of “still-supportive fundamentals, still-tepid equity sentiment and more reasonable valuations keep us positive.”
But in 2019, BofA now sees elevated likelihood of a peak in the S&P 500; not helping is BofA’s rates team calling for an inverted yield curve during the year (same as Goldman which expects the yield curve to invert in the second half), and with homebuilders peaking about one year ago and typically leading equities by about two years, the bank’s credit team is forecasting rising spreads in 2019.
The punchline: 2019 will end modestly below 2018, making 2019 the peak of this cycle, to wit:
Assuming the market peaks somewhere at or above 3000, our forecast is for modest downside in 2019.
How does BofA get its 2019 target? It explains below:
Our S&P 500 target model incorporates fundamental, technical and sentiment models, and as investor focus shifts toward longer-term growth, we increase the weight of our Fair Value Model and Long-term Valuation Model, and decrease the weights of our shorter-term sentiment model as well as our technical model. The weighted average of these models implies a 2019 year-end value of 2900 (+8% from today, but below our 2018 year-end target of 3000).
“What if we’re in a bear market?”
And while BofA provides several upside scenarios to its base case, the more interesting question the bank asks is what if Morgan Stanley is correct, and we are in a bear market?
To answer this question, BofA flags thatits bear market signposts briefly flagged 79% triggered in early October, and notes that “whereas credit conditions, sentiment, positioning and the yield curve would suggest we’re not done yet, it is worth considering that we are in a bear market now, and if so, what makes sense”
Next, the bank puts bear markets in context, and provides historical context of S&P 500 bear markets (20%+ price declines) since 1929. Across all these events, the market has seen a median peak-to-trough price decline of ~30%, with trailing P/E compressing to 12x at market trough from 18x at market peak.
Bear markets have historically lasted about a year and half, and the peak of the market has generally preceded an economic recession (if one occurred) by three quarters. EPS peaks have varied but have occurred on average two quarters after the market peak. EPS recessions (which have not occurred in every bear market) have seen an average ~20% peak-to-trough decline.
These observations are summarized below:
Here, the most relevant observations is that while not every bear market coincides with a recession, but the most painful ones do. The S&P identifies 13 bear markets since 1928, 10 of which have coincided with US recessions. The exceptions were 1961, 1966 and 1987, which were relatively short-lived and followed by swift recoveries.
How to think about recession timing: the general rule of thumb is that the stock market leads the economy by 1-2 quarters, and on average, the market has historically peaked 7-8 months before a recession. But the range has been wide: for example, in 1948 the market peaked 2.5 years before the start of the recession.
Another good timing indicator: keep an eye on the homebuilders, which as noted above, led market peaks by 2 years in last two cycles. In the current cycle, they peaked one year ago.
So if indeed we are in a bear market, what sectors should investors focus on? This is tricky because according to BofA, bear market returns for sectors might be different this time.
Historically, Health Care, Consumer Staples and Utilities have been the best performers during bear markets, while Industrials, Financials, Tech and Materials have fared most poorly. But the changing composition and fundamentals of sectors suggests that relationships for factors may be more consistent than sectors, and a historical framework may not necessarily apply. For example, as shown in the tables, below:
- Financials have typically lagged during bear markets, but held up better during non-financial driven downturns (e.g. +15% during the 2000 tech bubble). BofA believes that the sector can hold up better this cycle as well, with much healthier balance sheet and low risk of another financial crisis.
- Tech underperformed during 1990 and 2000 bear markets, but the sector is more mature and stable now. Valuations look more attractive at 16.7x forward P/E vs. 52.6x during the tech bubble and margins are double what they were in 2000-2007. It is the only sector with net cash, which can support stocks in the next downturn.
- Industrials have been a typical laggard during bear markets and were recently hit by escalating trade tensions with China and rising rates. The sector can outperform once trade issues resolve next year, according to BofA. The bank’s Political Control Model shows the midterm election result of a Republican Senate and Democratic House was the best outcome for defense spending. A potential infrastructure bill could also boost the sector outlook.
BofA concludes the analysis on two distinct notes, a positive and a negative one.
The first one is that despite the risk of a bear market, according to the bank’s economics team, even though by July 2019, this cycle will surpass that of the 1990s to become the longest in post-war history, recession risk remains low, according to their models, with the highest pointing to a 26% probability, although it concedes that “these can adjust rapidly.”
How do time the recession? BofA recommends watching jobless claims (which has historically jumped double-digits ahead of recessions) as a key indicator. In their view, a recession likely originates in the corporate sector (where high leverage represents a sign of “excess”), vs. in the household sector where leverage and housing investment are low.
The bad news? BofA expects the VIX to double by 2021, by referencing a popular correlation between the volatility index and the flatness of the yield curve. Specifically, a flattening yield curve signaled a withdrawal of liquidity and over the last three cycles has preceded rising volatility by a few years,
To hedge, BofA notes that volatility is not always synonymous with equity losses. From 1993 to 1998, the VIX rose from ~15 to ~25 amid S&P 500 total returns of 21.6% per annum. Between Jan 94 and Aug 98 (trough to peak in vol), High Quality stocks (S&P Quality Ranks of B+ or Better) have outperformed the Low Quality stocks (B or Worse) by 19.3ppt, or 3.9ppt per annum.
Then again, a sustained increase in the VIX traditionally correlated with a sharp drop in risk assets, which – whether the S&P is in a bear market or not – remains the biggest risk.
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