Now that the market has decisively entered into correction territory, two of the most bullish investment banks around, Goldman and Deutsche Bank, are long overdue for reports that describe just how this event was dully expected and in fact, priced in, and that investors should in now way draw and conclusions about a potential recession emerging from something as innocuous as a recession. Furthermore, the 10%+ pullback is "perfectly normal", and has no impact on either Goldman's 1,250 or DB's 1,375 end of year target for the S&P. And yet, there is a 'but' - both firms now sound far less confident than they did a few short months ago, and the hedging of year end targets has begun (more so at GS than DB). And while Goldman's report is more focused on the European context, and is thus appreciably more bearish, Goldman's tone is far more subdued than Deutsche's, which is understandable: with assets at two thirds of German GDP, and with a government dead set on minimizing bank bailouts for the foreseeable future, the German bank has far less margin for reality than the primary recipient of Hank Paulson's bailout generosity.
First, we present the opinion of Goldman's Sharon Bell, who most certainly is neither David Kostin nor A. Joseph Cohen.
The pace of global economic growth is showing signs of slowing, although the level itself remains high. It is frequently the case that markets suffer a setback when growth indicators turn down – even if other factors such as strong earnings growth and loose monetary policy remain in place. We analyze market corrections in previous similar periods and argue that much of the slowdown in growth is already now discounted.
In addition, the European market is facing other headwinds, namely sovereign debt risks, bank funding issues and concerns over fiscal tightening. We acknowledge that these concerns are likely to mean the risk premium stays higher for longer, and as such reduce our year-end target for the STOXX Europe (SXXP) to 280 from 300.
The primary client concern that Goldman attempts to address is the slowing momentum in various macro economic indicators. This is particularly relevant now that the ECRI leading economic index posted its 44th sequential weekly decline this Friday, and has for the first time plunged to an annualized negative rate. As Bell says:
The correction in the market can be attributed to a number of factors, including sovereign debt concerns, fiscal tightening, bank funding and the possibility of greater regulation from policymakers. All of these have contributed to the rise in risk perception and concerns over the medium-term outlook for growth. But fears have also started to accumulate about a slowdown in the current momentum of economic growth. In the US, there have been some weak payroll numbers, in Europe, the PMIs have come off their highs, and our proprietary global lead indicator (GLI) has started to show signs of slowing momentum (although the headline numbers are still very strong).
This point in the cycle, when growth has picked up from the trough but momentum is starting to show signs of peaking, is often a soft period for equity markets. We alluded to this at the end of last year in our 2010 outlook piece, Europe: Portfolio Strategy: Outlook 2010, December 2, 2010. We didn’t expect the falls that we have seen, but we did see the period when growth momentum started to slow as a trigger for a more subdued period of equity market returns, and discussed the risks of a temporary setback in equities (although this was not our core view).
This risk has now become a reality and it is useful to compare the falls seen in this current correction with those of previous similar periods. In Europe, there have been four correction periods that in our view are most comparable to today: 1976, 1984, 1994/95 and 2004. In each of these periods, there was a correction in the equity market that coincided with (or was very close to) a slowdown in the main lead indicators, the ISM, GLI, and the German IFO.
Goldman's empirical study indicates that in the US, of the five "corrections" which commenced at around the time the "growth" phase of the economy was ending, and was being supplanted by the "optimism" phase (toward the end of the economic expansion, when markets rise faster than earnings growth and hence multiples rise rapidly), on average record a 14% real correction for the S&P 500. On the other hand the 12 month pre correction rise in the market was 25%, not nearly the double seen from March 2009 to 12 month later, this begging the question just how relevant, if at all, any empirical studies on this matter are at a time of unprecedented monetary and fiscal stimulus. Additionally, as Rosenberg will point out, none of the prior discussed recessions were both a manufacturing and a credit crunch. This in itself renders Goldman's entire study worthless.
Goldman summarizes these results as follows:
There are a number of observations worth making:
- On average, the market fell by 13% during these corrections, 15% in real terms.
- So far, Europe has fallen by 15% and the US by 14% from the mid-April peaks.
- The duration of these corrections has averaged 150 days, or five months.
- So far, the current correction has lasted just under two months; if it should last a similar time to previous corrections, then October would mark a turning point.
- The rise in the market this time in the 12 months prior to the correction was 43% versus an average rise of 24% prior to historical corrections. However, there is no obvious relationship between the size or duration of these corrections and the rise in the market in the previous 12-month period.
- On average, the corrections do coincide with the peak in the survey data, but the market sometimes leads by a few months and sometimes lags.
Given that these corrections lasted only 4-5 months, a key question is what the catalyst was for markets eventually turning again.
A good question, and those interested can read up on it in the attached full presentation, which however as we pointed out in our opinion is fatally flawed, as there is no direct connection between a correction seen in the current environment in which the very survival of stimulus driven intervention is at stake, and prior plain vanilla recessions driven by economic overcapacity. The fact that Goldman even consider comparing such apples and organes is indicative of the naievete of some of the firm's economists (or their outright disdain for the intellectual capacity of their clients).
It is no surprise that based on the presented cherry picked data, Goldman says:
"We would not recommend a short position on European equities from this point; we continue to believe the valuation case is strong, that policymakers are ultimately doing the right thing in reducing fiscal spending and that this will not have a huge detrimental impact on growth (indeed, we believe quite the opposite)."
But, here is the but part:
But there are clear hurdles for the market; our economists expect growth in the US economy to slow to 1.5% qoq annualized in 3Q and 4Q of this year before the economy rebounds again from 1Q2011. At the same time, China’s economy is likely to gradually slow as tighter monetary conditions impact on growth. Finally, the concerns about the policy framework in Europe are unlikely to be fully addressed over the next few months.
Given this, we acknowledge that the risk premium is likely to stay higher for longer. We therefore lower our year-end target for the STOXX Europe to 280 from 300 and now expect the STOXX Europe to reach 300 only in 12 months’ time. On a threemonth basis, we move our SXXP target down to 250 from 270 and on a six-month view, we move it down to 280 from 290.
However, these targets still represent reasonable returns on the year. Our new year-end target implies a nominal price return of 10.3% for 2010, roughly in line with the historical average real price return in the Growth phase of 10.9%.
And while Goldman's attempted defense of the status quo comes off as marginally credible if rather disingenuous, DB's analysis of why the correction is unlikely to be disruptive is a work of art. The ever optimistic Binky Chadha leads of with the following:
Equity market corrections outside of recessionary periods have typically not derailed economic recoveries. Out of the 14 such post-war episodes, only 3 eventually slowed payrolls growth. Common to all 3 of these episodes were equity market declines of more than 20% and sell downs lasting more than 7 months. These were joint necessary conditions. In the current context, this would imply the S&P falling below 975 and the correction dragging on till mid-November. But fundamental initial conditions are also important and, in our view, the main cyclical driver of the current recovery, the large gap between final demand and corporate activity levels, remains and will continue to drive corporate spend and hiring.
The full-on assault against any bearishness continues:
Historically, episodes of risk aversion have lasted an average of 2 months, which translates to mid-July for the current episode. As to fundamental catalysts, first, we see mutual funds and long short equity funds as defensively positioned, while non-dedicated equity investors are short equities and record short the euro. A positioning squeeze is possible at any point, but to sustain will likely require other catalysts. Second, a heavy calendar of Euro-periphery debt rollovers in July argues risk aversion will persist through then. Third, Q2 earnings reporting season begins mid-July. Investors have covered underweights going into recent earnings seasons. This time, concerns about euro appreciation and slowing growth may make them slower to cover, but with many companies noting limited impacts, it remains a distinct and likely possibility. Fourth, we view last week’s payrolls as leaving the labor market recovery trend intact. Labor income, the driver of consumer spending, grew at a healthy 7% annual rate. The trend in payrolls also indicates the recovery in the labor market is on track though jobs growth in earnest will begin only in July, reported in the first week of August.
How naive of us to think that Mr. Chadha would mention even one of the relevant economic statistics this time around, such that the labor market is now completely distorted courtesy of the millions of transient workers entering and leaving thanks to the census. But yes, pointing out that companies see limited impact of a historic move in the FX scene, with the dollar now back to post-Lehman highs, is truly value added. Maybe next Binky can deconstruct the great foresight the Fed's Chairman had in 2006 when he said the subprime crisis was contained, and when in 2007 all major IB economicsts saw an S&P north of 1,600 by the end of the following year.
Just in case the DB spin is not quite heard, Binky continues:
Our baseline remains that the economic recovery will continue, driven as it has been so far by the large sales-production gap which remains sizable. On this baseline view and the implied path of corporate earnings, equities are inexpensive (S&P 500 trading today at 12.7x 2010, 12.3x normalized and 11.3x 2011 earnings) and will likely correct up as they have in past episodes when corrections did not disrupt the economic recovery. We therefore maintain our year-end target of 1375 (16.4x $84.6) on the S&P 500. But the rally in equities reconnecting to the economic recovery will likely take time. Both history and a variety of fundamental catalysts suggest risk aversion will persist through July and this is our baseline view. The persistence of risk aversion or vol by definition of course means that the range for the S&P can and likely will be large. Indeed a narrowing of trading ranges would be a sign that the episode of risk aversion was coming to an end. Key levels in the S&P 500 to note are (i) 975 which would mark 20% down and what history suggests is a necessary condition for disrupting the recovery; and (ii) 915 which would mark 25% down, which is the average recession decline from the recent 1217 peak, i.e., the market would have completely priced in another average recession. On the duration of risk aversion, we see the risks from the fundamental catalysts on net as being tilted to risk aversion ending earlier than in our baseline of end July, either on a positive surprise in June payrolls or an unwind of defensive positioning as Q2 earnings deliver or provide the sixth surprise in a row. We stay fully allocated to equities.
Well, of course you do. And we would venture to guess that the stock of DB is one of the main equities you stay allocated to, as the last thing a bank as massively undercapitalized as DB needs is for the economic reality to catch up with those firms levered to the gills to an economic upturn.
Yet DB does point out one useful data point, namely that cross asset, sector and stock correlations have now spiked to 20 year highs, as the only thing driving the market are daily shifts of risk perception, and the resultant signal execution by the few computers left trading the market amongst each other. At this point, we are confident that should the current pace of market structure deterioration continue, coupled with ongoing sovereign liquidity and solvency risks, that within a few months cross correlations will finally hit 100% and all alpha-hunting hedge and mutual funds can dissolve as the only variable in stock returns will be pure beta, thus making any relative outperformance in the market impossible by definition:
Cross asset class correlations, measured by the proportion of variation in returns across equities, bonds, credit, oil and FX that is explained by the first principal component, reached a new high of 65%--above late 2008 post-Lehman peaks. Across S&P 500 sectors (93%) and stocks (75%) it also reached late 2008 peaks. While vol rose sharply, the move has been below the average of past risk aversion episodes. We interpret the high cross-asset, sector and stock correlations as indicative of investors in less liquid asset classes hedging in more liquid equity and FX markets, using the indexes to do so.
Below are some of the more interesting charts from DB on market technicals and cross-correlations:
Notably, the S&P 500 has seen a very minor % change in EPS estimates since May 20, 2010, even as companies continue to pump up earning beat after earning beat, as more and more people continue being let go, and capex plans are reduced.
And specifically on the topic of corrections, here is the chart that allegedly demonstrates that while of the past 14 corrections, only 3 have resulted in payroll slowdown, and thus the ongoing "correctional" situation should be considered safe.
In other words, to DB the critical low in the S&P, which has likely been telegraphed to the relevant market supporters, is 975. Should that level be taken out, even DB would be forced to admit that the economic double-dip has arrived. As expected, there is little mention of previous observations by both David Rosenberg and Shiller, both of whom repeatedly point out that at current levels the market is approximately 30% overvalued, based on a bottoms-up analysis. In summary, both firms are right in noting that the economic-market disconnect is starting to shift to the economy proper, as the variation between macro and micro economic indicators is starting to flash red warning light. Should the relative strength of corporate bottom line metrics, which we believe has been driven almost exclusively by ongoing years of mass layoffs and retrenchment, leading to SG&A and CapEx reduction, thus sacrificing future revenue potential, invert, then even this last bastion of economic bulls will be abandoned. It is our belief that corporations, especially multi-national exporters, will increasingly indicate future top line weakness as a result of unhedged FX losses leading to end market weakness. This will likely be the next catalyst to push the corporate micro picture to recouple with increasingly weaker macro readings.