After two weeks of violent market whipsaws, which saw the S&P rally by 5% two weeks ago, then drop by the same amount last week with the VIX surging to 23, Goldman’s chief equity strategist David Kostin writes that the bank’s clients remain nervous with concerns rising over three key market themes: i) US-China trade relations, ii) the pace of Fed tightening, and iii) concerns about recession.
To be sure, there is reason to be worried – as Bank of America summarized over the weekend, following the second 10% correction of the S&P in 2018, “the capitulation has begun”, and while “everyone is bearish, nobody is short.” This has led to a jump in market swings – a traditional late-cycle indicator – with the S&P 500 having no less than 56 daily moves of more than 1% this year, versus only 8 last year and a calendar-year median of 49 since 2010. Additionally, as Driehaus Capital notes, the S&P has also had more 2% and 3% daily moves than any year since 2011 as traders scramble to jump on directional momentum, only to find none exists.
Adding to the confusion is that while a recession – according to most – remains unlikely in the short to medium-term, the US economy is clearly slowing down as the latest print of the Citigroup US Econ surprise index demonstrates.
Additionally, while November payroll growth was softer than expected, other economic data remained firm: the ISM manufacturing index rebounded to 59, with particularly strong New Orders (62), and the ISM non-manufacturing index was higher than expected, and as the chart below implies, the S&P 500 appears to have priced in a more drastic slowdown in economic growth than what manufacturing surveys expect.
So what is Goldman advising its confused clients to do now?
According to Kostin, with an increasingly uncertain economic background, coupled with renewed concerns about the US-China trade war and the Fed’s balance sheet, in 2019 Goldman expects “a continued environment of low risk-adjusted US equity returns.” As the bank outlined in its 2019 outlook, it forecasts a combination of modest absolute returns to the S&P 500 and elevated risk.
Our baseline forecast is for US economic growth of 2.5% and earnings growth of 6% to drive the S&P 500 to 3000 by year-end 2019. If realized S&P 500 volatility matches the 30-year average, the risk-adjusted return in 2019 for the S&P 500 would equal 0.5, well below the long-term average of 1.1.
However despite its upbeat year-end price target, and echoing other banks’ increasingly cautious stance, Goldman also lays out an upside and downside case, which would see the S&P rise either as high as 3,400 or drop as low as 2,500.
Kostin also notes that “numerous risks threaten the bull market” and for the first time in a decade, cash represents a competitive asset class to equities as the current forward market pricing suggests a 3-month T-Bill rate of 2.75% at the end of 2019.
The good news, for traders if not so much investors, is that tactically the S&P 500 appears to have priced a more substantial slowdown in growth than Goldman expects. The S&P 500’s -0.1% trailing 12-month return has historically corresponded with an ISM manufacturing index level of roughly 50, well below the most recent reading of 59.
Similarly, the performance of the bank’s Cyclicals vs. Defensives baskets implies that the S&P 500 is currently pricing US economic growth substantially below its US Current Activity Indicator of 2.8%.
And while Goldman economists forecast a deceleration in economic activity from 2.9% in 2018 to 2.5% in 2019, recent equity market performance implies a more dramatic slowdown than our baseline, which leads to the following bullish near-term reco from Kostin.
Accordingly, we believe there is short-term upside to the S&P 500.
Which brings us to the bank’s top trade recos, the first of which is for investors to own “quality” in 2019 given elevated risk, with Kostin explaining that as economic and earnings growth decelerate and financial conditions tighten, “investors should be increasingly focused on companies best-positioned to withstand late-cycle pressures.”
The bank notes that stocks in its High Quality basket (ticker: GSTHQUAL) should outperform in this environment due to their combination of strong balance sheets, stable sales and EBIT growth, and low drawdown experience. It also recommends investors own stocks with strong balance sheets (GSTHSBAL) and recently upgraded the low-beta Utilities sector to overweight, reflecting similar versions of “quality.”
What about the recent debate whether it is time to rotate out of growth and into value? Here Kostin is more ambivalent, noting that “volatility this year has widened P/E multiple dispersion and improved the case for Value, but the economic environment still favors Growth.” Additionally, while decelerating economic growth would usually suggest further Growth stock outperformance, on the other hand, widening valuation dispersion, concentrated investor positioning, and recent weakness in EPS revisions complicate the picture. As a result, Goldman seems to edge in favor of Value over Growth, at least until recent market gyrations subside.
Valuation dispersion has historically been a strong predictor of future Value performance. When the distribution of stock valuation multiples is narrow, returns are differentiated by growth and other fundamental qualities rather than differences in multiples. Multiple dispersion has widened during recent volatility and points towards a more favorable environment for Value stocks next year.
For investors who wish to combine the best of both Value and Growth words, Goldman recommends its newly-rebalanced High Sharpe Ratio basket which “offers tactical investors one screen for value stocks with a “quality” overlay. The sector-neutral basket (GSTHSHRP) consists of an equal-weighted portfolio of 50 S&P 500 stocks with the highest prospective risk-adjusted returns.”
The median constituent in this basket which is being rebalanced to include 35 new constituents, “is expected to post 2x the return as the median S&P 500 stock with only modestly higher volatility, resulting in 2x the prospective risk-adjusted return (1.1 vs. 0.5).”
By construction, the High Sharpe Ratio basket carries laggard and value tilts, as stocks screening into GSTHSHRP have often experienced substantial price declines. However, resilient analyst price targets reflect ongoing confidence in the companies’ fundamentals.
That said, it would be better for investors not to have bought into this reco at the start of the year as the median stock in the basket has a YTD return of -19% (vs. -1% for S&P 500 median) and trades at 13x forward earnings (vs. 16x for S&P 500 median). Stocks with the highest prospective Sharpe Ratios: NFX, NWSA, NKTR, SLB, HAL, FLR, PWR, and KORS.
So how does Goldman justify this recent underperformance, and why does it believe the basket will be a winner going forward?
The High Sharpe Ratio basket has underperformed the S&P 500 YTD but has a long-term track record of outperformance. The basket has lagged the S&P 500 by 10 pp in 2018. GSTHSHRP’s risk-adjusted YTD return also ranks in just the 2nd percentile relative to large-cap core mutual funds. However, since 1999, the strategy has outperformed the S&P 500 in 68% of semi-annual periods and generated an average 6-month excess return of 310 bp (roughly 620 bp annually). GSTHSHRP’s average semi-annual information ratio of 0.3 ranks in the 88th percentile of large-cap core mutual funds since 1999. The basket performs best during regimes of above-average volatility, generating an average excess return of 320 bp in periods with realized volatility greater than 15 vs. 130 bp of outperformance when realized S&P 500 volatility measures less than 15.
Finally, Kostin has one specific seasonal observation, noting that laggards have historically continued to underperform in December but rebound in January, and according to the Goldman strategist one possible explanation for this seasonal pattern is the tax loss selling of laggards at year-end.
Although the effect is generally found to be stronger in smaller cap stocks, we also find signs of seasonality in our momentum factor using S&P 500 companies. Since 1980, January has typically been one of the worst months for our momentum factor, as laggards reverse and outperform.
Of course, with markets increasingly on edge as a result of the ongoing perfect storm of trade, hawkish central bank and economic headwinds, tax-loss selling will likely be the last thing on anyone’s mind should last week’s selloff accelerate in the last three weeks of the year as the realization that buying the dip no longer works (as Morgan Stanley infamously demonstrated in October), dawns on even the most optimistic market participants, especially if stock buybacks begin to exit stage left as companies become increasingly reluctant to issue debt at a time when debt issuance costs are rising rapidly while the loan market is on the verge of freezing.
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