Despite near record corporate earnings, the S&P has continued to trend lower for 6 weeks: the longest drop since 2002 as reported yesterday. But have no fear: Goldman's David Kostin summarizes the upside/downside potential of the market (1450/1210 on the S&P), and the key bullish and bearish factors that help determine the current outlook. "Discussions with clients this week focused on the risk/reward balance for US equities. Our forecasts reflect a 2:1 upside/downside return profile through year-end 2011. S&P 500 has declined by 5% from its April 29th closing high of 1364. Our year-end 2011 index target remains 1450 representing 12% upside from current levels. A downside scenario suggests an index value of approximately 1210 or roughly 6% below current levels." Also, Kostin is confident the current sell off is overdue to reverse "During the pull-backs the median length time for the market to reach bottom equaled 27 days. Six of the episodes took 20-40 days and on four occasions the decline occurred in less than two weeks. The current sell-off has lasted 41 days and counting. The historical episodes we analyzed had a median time to recover of 41 days. Recoveries during 2003-07 typically took longer than the speedy rebounds since 2009." Needless to say comparing the current centrally planned regime to any other time is futile, and we completely disagree with his assessment.
More from Kostin
Looking ahead, bullish arguments include positive EPS revisions, loose financial conditions, undemanding valuation, and lower options skew. Mutual fund outflows and stalling growth represent risks to our outlook.
Growth: disappointing reported and forward-looking economic growth metrics have led the market lower. Reported economic data has been below consensus since April. Our Economics team’s June US MAP score was the lowest since our data series began in 2001. We estimate the market has reduced its outlook for US GDP growth by about 50 bp to 2.5% since April based on our US Wavefronts Growth basket. Our earnings model suggests that a 50 bp shift in US GDP growth translates into $2 in annual EPS. Our current estimates include annual average growth of 2.6% in 2011 and 3.2% in 2012. If GDP growth is only 2.1% in 2011 and 2.7% in 2012 our EPS estimates would fall to $94 and $101, respectively.
Earnings: S&P 500 consensus 2011 and 2012 earnings estimates are up during the past month. The same is true for six of ten S&P sectors. Our earnings revisions sentiment indicator, which measures the balance of positive and negative revisions, is also positive for eight sectors. Broadly speaking, earnings estimates have risen for the market and most sectors, providing support for fundamental investors ahead of the 2Q earnings.
Valuation: remains reasonable with attractive risk/reward, in our view. S&P 500 P/E is just 12.5x (on forward 12 month consensus EPS) and 12.9x relative to our forecast EPS. The S&P P/E multiple has averaged 13x since 1975 and more than 16x since 1990. Valuation is similarly modest on a P/B basis, particularly given our 17% estimate of S&P 500 ROE. At this time last year, when investors worried about a possible double-dip US recession in 2H 2010 and Europe sovereign credit defaults, the S&P 500 P/E multiple was 12.0x our estimates. Applying that multiple to our 2012 EPS estimate under a lower growth scenario yields an S&P value of 1212 (12 * $101), 6% below the current level but attractive risk/reward vs. the 12% upside to our yearend target of 1450.
Fund flows: have turned negative. Domestic equity mutual funds have experienced outflows in four of the past five weeks totaling $3.5 bn. Funds started the year with just one week of outflows during the first four months and cumulative inflows of nearly $30 bn.
Risk sentiment: has lagged the market sell-off. Options skew, a measure of downside risk sentiment, has actually declined during the market sell-off. Implied volatility has moved higher but less than might be expected: 1-mo. implied volatility is up 3 points since April 29th. Historically, the latter part of business cycle expansion includes lower, but still positive, returns and higher realized volatility that lower risk-adjusted returns.