Goldman Sachs Admits The Truth: "The Economy Is Not The Market And QE2 Is Not A Panacea"
In a stunning turn of honesty, Goldman's David Kostin does a 180 and renounces everything that the Fed wishes the gullible public would swallow hook line and sinker. But first the facts: while the strategist has no choice but to raise his 12 month S&P forecast (this is a new development for all the headline chasers) from 1,250 to 1,275, which is a token nothing compared to the recent 12 month gold price boost from $1,365 to 1,650. This merely reinforces the Zero Hedge view that gold has now become the natural, higher beta, and unlimited upside short hedge to stocks. Indeed, a 1% boost in the S&P PT, is meager compared to the 20% expected gold appreciation. And digging between the facts, we encounter this stunning admission, that would force all current and former Fed chairmen to spin in their graves, assuming a deceased state is attributed them all: "The economy is not the market and QE2 is not a panacea." Read that again, because this is only the first time in history a sellside advisor, especially one who works for Goldman Sachs, has said this truth so fundamental, that nobody actually dares to admit it, least of all the public or the Fed. Below, we present the latest strategy piece by David Kostin which is probably about the most bearish note released by the traditionally permabullish successor to Abby Cohen.
Key points from Kostin's price target update:
In our view, three unrelated items combined to push US share prices higher:
- September’s batch of positive macroeconomic data surprised to the upside for the first time in five months. The Goldman Sachs aggregate monthly US-MAP score measuring the magnitude and relevance of economic data hit the highest level since June 2009;
- Polls indicate the November 2nd mid-term Congressional elections will likely see Republicans gain control of the US House of Representatives and narrow the current Democratic majority in the US Senate. A divided government may reduce the policy and regulatory uncertainty that many business leaders claim has hindered capital spending decision-making; and
- Comments from various Fed officials made it increasingly clear that the Fed intends to initiate a second round of quantitative easing (QE2) following the upcoming FOMC meeting on November 2nd and 3rd. Ten-year US Treasury yields have dropped 20 bp in four weeks to 2.57%. For context, yields peaked this year at 4.0% in early April.
Goldman's official 12 month price target:
We expect the S&P 500 will rise another 2% to reach our year-end 2010 target of 1200. We anticipate US equities will trade sideways during 1Q 2011 as economic uncertainty remains high. Our revised 12-month price target of 1275 (from 1250) reflects a potential price return of 9% from current levels. The cost of equity should decline slightly as 2011 progresses and investors turn their attention to the economic growth prospects for 2012.
And since Goldman has decided on what it deems a goldilock price target, the firm admits there are various risks both to the upside and downside. Although with this bizarro economy, any "risk" of good news would likely send the stock market plunging, and vice versa. Which is why we reiterate our call to REDI creators Spear, Leeds and Kellogg to invert the buy and sell orders to at least make bizarro "selling" on bad news some what intuitive:
Risks to our view include a jump in management confidence leading to acceleration in capital spending; a decision by individual investors or pension funds to re-allocate assets from bonds to domestic equities; a rise in trade protectionism; a US municipal finance crisis, another European sovereign credit market dislocation, and a protracted economic slowdown in emerging markets generally and China in particular.
A visual summary of Goldman's recent action:
Kostin highlights the key topics that will drive US equities over the next several months:
1. Earnings season (October 18th-November 5th). The crescendo of quarterly reporting season is upon us and 395 companies in the S&P 500 (78% of the equity cap) will report 3Q earnings results in the next three weeks (Oct 18th to Nov 5th). As we discussed in our October 8th report, 3Q 2010 Earnings season preview: We expect positive EPS surprises, current bottom-up consensus expects 3Q earnings to be below 2Q actual results for the overall S&P 500 and for six of the 10 sectors (see Exhibit 4).
US economic activity during 3Q was positive, albeit below trend, making it unlikely that S&P 500 earnings will decline sequentially from 2Q to 3Q. Current consensus expects 3Q 2010 revenues (ex Financials and Utilities) will rise by 6% year/year while EPS for the same cohort of companies increases by 19% (30% for the entire S&P 500 including Financials and Utilities) (see Exhibit 5).
2. Mid-term elections (November 2nd). All elections have consequences, but the stakes seem especially high this cycle. Many portfolio managers view the prospect of a divided Congress as positive for equities in terms of reduced legislative uncertainty. Simply put, investors believe gridlock is good for equity markets.
A change of control election in the House and/or Senate has generally been associated with positive returns during the subsequent 12 months. The average gain in the S&P 500 during the 12 months following the six Congressional change of control elections since 1950 (including two Presidential election years) equals 11% with minimum and maximum returns of -4% and 33%, respectively (see Exhibit 6). Historically, the S&P 500 has generated positive 12-month returns following all 15 mid-term elections since 1949.Returns ranged from 3% to 33% with an average of 18%.
According to RealClearPolitics.com, an independent political web site that aggregates polling data, Republicans seem likely to gain control of the House of Representatives while Democrats appear likely to retain their majority in the US Senate.
Polls as of October 13, 2010 show 211 seats in the House of Representatives as safe or leaning Republican, 185 seats as safe or leaning Democratic, with 39 seats considered “toss- ups.” Majority in the 435-seat House requires 218 votes and 38 of the 39 toss-up seats are currently held by Democrats. RealClearPolitics.com shows 48 seats in the US Senate as safely Democratic or not up for election (including 2 independents who caucus with the Democrats), 46 seats as safely Republican or not up, with 6 seats considered “toss-ups.” All six “toss-up” seats are currently held by Democrats.
We recognize that many investors believe a divided government is good for equity markets. However, clarity is needed in areas such as tax policy. The 2001- 2003 tax cuts will sunset on December 31, 2010 and capital gains, dividend and estate taxes will all increase sharply if Congress takes no action during the truncated lame duck session following the election. For additional details see US Economics Analyst: Thoughts on the Midterm Election (October 8, 2010).
3. Quantitative Easing (November 3rd). The widely held consensus view of both buy- and sell-side economists is that the Fed will initiate a second round of quantitative easing (QE2) following the November 2nd-3rd FOMC meeting. Various estimates exist regarding the specific size and form of the asset purchase program. Although it will probably start smaller, our US Economics Research group believes Fed purchases of US Treasuries will cumulate to $1.0 trillion or more.
The decision to begin QE2 represents an explicit acknowledgement by the Fed that US economic growth remains extremely weak and unemployment is likely to remain much higher than its policy mandate. Given public statements by Fed officials that inflation is also running below its target, the Fed’s upcoming QE2 initiative is a dramatic attempt to create inflation—or at least inflation expectations – and rouse the economy from its torpor.
Reflecting on the client meetings we have hosted during the past few weeks, most investors’ are optimistic regarding the market impact of the Fed’s actions. These investors believe the market will continue to rally even after the Fed’s announcement next month.
There is friction between macro and micro investors’ interpretation of the impact of QE on equities. In the broadest terms the affirmative macro case for QE2 rests on easier financial conditions and the goal of asset price inflation. The skeptical micro view is that additional easing is an acknowledgement of the weak US growth outlook and will not drive earnings meaningfully higher in the near-term. We discuss these views in more detail below.
Furthermore, on the topic of QE2, Kostin reaffirms what we noted last week was Hatzius' expectation that the bulk of QE2 has already been priced in:
Our rough estimate is that $1 trillion of QE2 could drive 8% to 10% of upside for US equities but that much of that move may have already occurred. Using the impact on financial conditions and asset prices of the first round of QE as a guide, our US Economics team estimates that an announcement of $1 trillion of QE2 could move the S&P 500 8% higher with additional upside to 10% in the ensuing month. They believe the market began anticipating QE2 in early August in response to FOMC announcements and media reports
at the time.
Over time we believe QE2 will be positive for US equities through reduced economic uncertainty and price support (multiple expansion and lower interest rates). However, a meaningful amount is already reflected in recent S&P 500 performance and our take on investor expectations. Moderately below consensus reported economic data could also offset security purchases.
And the biggest condemnation of QE2 from Goldman:
If QE2 won’t meaningfully boost earnings (although it should over time as GDP growth improves) then the transmission mechanism to higher stock prices must come via another route. The bullish argument that QE2 will raise the price of risky assets rests on the notion that lower interest rates will reduce the cost of equity and applying a lower discount rate in a DDM will raise the present value of future earnings and dividends and thereby boost the current fair value of stocks.
We agree with the theoretical argument above that a lower cost of equity raises the fair value of stocks. However, as a practical matter a lower cost of equity is simply another way of saying that stocks should trade at a higher P/E multiple.
Yet there is little to support a multiple expansion story at this point:
The link between QE and P/E: Money Flow
Positive money flow will be needed to expand S&P 500 P/E multiples above its current level of 13.4x, slightly above with its 35-year average. At a minimum a firm bid must exist from the marginal buyer such as hedge funds and retail investors. In our view, the lack of money flow into domestic equities represents the key obstacle to US stocks trading substantially above their long-term average following the 30% P/E multiple expansion in 2009. Exhibit 10 shows the ownership of US equities since 1952.
Individual investors own more than 50% of US stocks. Direct share ownership totals 33% and indirect ownership via mutual funds accounts for another 21%. In response to the dislocation in equity markets during the past two years individuals have consistently reduced their holdings of actively managed domestic equity mutual funds. Since the start of 2009, more than $1.0 trillion has been withdrawn from money market mutual funds. None of the assets was re-directed to domestic equities. Instead, 60% was invested in bond mutual funds, with 6% allocated to international stocks. Additional proceeds may have been used to reduce debt or fund living expenses.
Looking ahead, money often follows performance. Therefore, a sustained uptrend in stocks could lead to net inflows. In terms of QE2, if the Fed pushes interest rates lower across the yield curve individual investors might shift their allocation again, this time moving from bonds to stocks. Given the assets involved, such a move could have dramatic impact on share prices. ETFs will likely continue to take market share.
We expect pension funds and government retirement funds are likely to at least maintain their roughly 17% ownership share of the domestic equity market. But given how significantly underfunded many pension plans are, a situation which is only exacerbated by QE2, these funds should arguably increase their equity exposure and reduce their bond allocation. In aggregate these organizations could have a dramatic impact on the overall index level should CIOs choose to adjust long-term asset allocation.
The third ownership category worth highlighting is companies themselves where total cash positions, cash/asset ratios, and free cash flow yields stand at or near alltime highs. Firms in the S&P 500 hold cash equivalent to roughly 12% of the equity cap of the market. Managements faced with the prospect of extremely low yields on their short to intermediate term cash, but reluctant to fund new capital spending projects, could decide to buyback shares. Although repurchase would have a positive impact on share prices, it would not drive economic growth.
Bottom line: if this is the most bullish Goldman's equity strategist can come up with, watch out. We still believe the simplest explanation for the parabolic ramp in stock is to simply create the highest possible selling point before tax selling commences in advance of January 1, and much higher capital gains taxes. Everything else is for the most part noise. Already sellers outpace buyers by 1,000 to 1. We expect within the next few weeks this ratio will hit five digits.