Until last Friday, there was one ominous comparison being thrown around for the stock market: the burst in the S&P for the month of January was the best start to a year going back all the way to the infamous 1987, when the year ended sharply lower despite its own January euphoria.
Now, one week later, there are other, more troubling comparisons to 1987, and specifically that year’s “Black Monday” crash. First, from a purely economic perspective, David Rosenberg summarized it best last week noting the sharply “rising bond yields. Full employment. Fed tightening. Trade frictions. Weak dollar. Rising twin deficits, spurred by tax reform. Sound familiar? It should. This was 1987.”
Then, last week’s widely telegraphed market drop finally happened, one which sent the Dow Jones lower by 1,000 point in the span of 5 days and which with its demonic 666 point plunge on Friday, was also the 6th biggest daily point drop in Dow Jones history.
All of the above appears to have spooked Goldman’s clients who – as David Kostin writes in his latest weekly Weekly Kickstart – have one nagging question: is this 1987 all over again.
Despite market volatility this week, the S&P 500 has risen by 3% YTD. The 3.9% decline from last Friday’s close eclipses the 2.8% max drawdown of 2017. Nonetheless, 2018 ranks as just one of 13 years since 1950 to start with a January return greater than 5%. The volatile start of 2018 surprised many investors and caused clients to ask if they should [A] raise their return expectations for the full year, or [B] expect a sharp correction. In particular, investors ask about the likelihood of a repeat of 1987, when a 13% January return and additional 20% rise through August were destroyed on Black Monday, Oct. 19, when the index fell by 20%. The full-year return was 2%
Here Goldman is put in the awkward position of having to defend its year-end price target of 2850, which was briefly eclipsed in the past week, as the S&P was melting up in an unprecedented “blow off top” eruption. So on one hand, Goldman’s chief strategist has to explain why he is still bullish, and on the other, why there is virtually no upside left yet why Goldman’s clients shouldn’t sell their holdings and pack it in for the year. This is how he does it.
In November we described our outlook for 2018 as one of “rational exuberance.” Our expectation was that EPS growth of 14% would lift S&P 500 to 2850 by year-end, but that valuations would remain flat in contrast to the bull market that ended in 2000. With S&P 500 sitting just 3% below our year-end target, significant further appreciation will require either an upward revision to our EPS growth forecast or belief that “irrational exuberance” will lift multiples. The latter scenario would increase the likelihood of a subsequent correction, in our view. Of course, as our colleagues recently noted, a third possibility is that the market suffers a near-term correction before the bull market resumes.
Ok, so, upside is capped because the alternative is a full-blown bubble meltup which will result in a crash. On the other hand, Goldman wants you – its client – to know that a more methodical grind higher should not provoke flashbacks to 1987, preventing it from becoming a sell-fulfilling prophecy as everyone dumps at the same time, something we saw on Friday.
This is how Goldman makes the case that what we saw is not 1987.
Unlike in 1987, the equity market’s YTD rise has been driven primarily by accelerating earnings growth. Record revision sentiment has lifted the consensus bottom-up 2018 EPS estimate by 7% since November. It now stands at $156, representing 18% growth vs. 2017. The bulk of the optimism reflects the incorporation of tax reform into analyst estimates. EPS growth and revisions have contributed all of the S&P 500 YTD return, whereas P/E expansion drove the entire index rise in January 1987.
Goldman then really doubles down, and desperately hopes to reassure you, its skittish client, that not only were there notable differences between 1987 and now, but that other years had just a strong start as 2018 and did not end in a fiery inferno.
By focusing on 1987, investors overlook other historical episodes that suggest a much better outlook for US equities in 2018. Of the 12 other years since 1950 that started with a January return greater than 5%, 1987 is the only one in which the February-December return was negative. Across all episodes, the median 11-month return was 17%
At the risk of pointing out that Goldman is protesting just a little too much, it is perhaps worth asking why are Goldman’s clients so eager to compare the current environment to 1987: is it because of all those economic similarities listed by David Rosenberg last week, or because the “muppets” dumb as they may be, realize that without the Fed backstopping this whole charade, the crash that is coming will make 1987 seems like a dress rehearsal.
Ironically, in the very next paragraph Goldman admits that left on their own devices, a crash is inevitable, here’s why:
A further market rise is unlikely to stem from valuation expansion. The median S&P 500 firm currently trades in the 99th percentile of historical valuation on a variety of metrics. Although near-record valuations suggest disappointing long-term returns, multiples are typically poor predictors of short-term performance. Nonetheless, rising short-term and long-term interest rates should limit further P/E multiple expansion. At 2.8%, the US 10-year Treasury yield has risen by 40 bp in the last two months and now stands at the highest level since 2014. We expect it will reach 3.0% by year- end as the term premium rises and the market moves toward our economists’ forecast of four Fed rates hikes in each of 2018 and 2019.
But the biggest risk to a coordinated liquidation is neither fundamentals, nor vivid recollections of Black Monday (by those traders who were at least alive when it happened), but investor positioning. As of this moment, institutions and hedge funds have never – ever – been more bullish:
CFTC equity futures positioning data show that investors increased long US equity positions by $40 billion this year, bringing long and net positions to new record highs(see Exhibit 4). Similarly, NYSE net margin debt is at its highest level relative to market cap since at least 1980.
And after a week like the last, if what was until recently going only up no longer goes up, there is just one alternative: down, express elevator style. It will be amusing to watch as the record net long exposure turns not so net long, especially with traders having forgotten how to sell thanks to sentiment at the highest on record.
Which brings us to Goldman’s tacit hint what happens next: “Investors who are already long cash equities could instead consider purchasing puts as protection”, which ‘curiously’ is precisely what Morgan Stanley said two weeks ago.
NYSE, October 19, 1987.
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