Will QE2 Impact Equity Market Fundamentals: Consensus And Fringe Views

Tyler Durden's picture

In his weekly "kickstart" piece, Goldman's David Kostin shares a glimpse of how portfolio strategists view the impact of QE2 on UW equity market fundamentals. In a nutshell, per Goldman bulls cite 20% upside to Fed model and a lower equity risk premium. Goldman is far less optimistic: "We believe QE2 is unlikely to change our sales or margin forecasts, so return prospects become a valuation debate. Our targets imply less upside, given 13.5x P/E is consistent with prior 1-2% real rate regimes." Furthermore, Goldman's economic team has already priced in $1 trillion of QE2 in its 2011 GDP forecast of 1.8% (below consensus of 2.5%), meaning at worst the overall economy will continue to operate at negative growth rates, once Q3 GDP is revised lower and Q4 GDP found to be negative following the inventory crunch. As Kostin puts it: "The US has a demand, not a supply, problem." Alas, the Fed is completely unable to grasp this. And the more it tinkers with the market, and the more fundamentals are disconnected from reality, the less Americans will trust the economic situation and retrench even more, leading to an even more pronounced demand "problem." As for markets, AJ Cohen's successor hits it right on the head: "We believe the forward path of stocks will be determined by potential asset allocation shifts by owners of 70% of the US equity market. Individuals own in aggregate 53% and pension funds own 17%. Shares will trade sustainably higher if these investor groups decide to re-risk from bonds to stocks. Any shifts most likely will be gradual." In other words, unless investors regain their faith and confidence in stocks, the market will merely trade on Fed liquidity and not on anything resembling fundamentals... or reality.

More insights from Kostin:

The consensus view is the Fed will announce next Wednesday, Nov 3rd that it intends to start buying US Treasury securities. Clients have coalesced around the belief the initial announcement will be $500 billion in size, with an indication of willingness to purchase up to $1 trillion. Another possibility is the Fed might announce an initial purchase of $100 billion of securities and a commitment to buy a similar amount per month for an extended, but undefined, time period.

The bullish argument for equities goes as follows: (1) The Fed buys longdated Treasuries to reduce term premium and lower interest rates across the maturity spectrum; (2) The low yields penalize individuals and corporations who hold cash; (3) individuals and institutional investors re-allocate their savings into higher risk instruments such as equities, high yield bonds, emerging market debt and equity, and commodities; (4) firms pursue new capital spending initiatives and boost employment; (5) asset price inflation has a wealth effect and spurs retail spending; (6) a consequence of lower US interest rates is a weaker US Dollar which benefits US exporters and also stimulates some incremental domestic job growth.

Our year-end 2010 price target for the S&P 500 remains 1200 or 1% above the current level of 1183. We expect the S&P 500 will trade sideways during 1Q before rising during the subsequent six months. Our 12-month forecast of 1275 reflects a price return of 8% and a total return including dividends of 10%. For details, see our report US Equity Views: Updating our price targets as investors focus on 2011 (October 15, 2010).

We expect the level of the S&P 500 will track the path of EPS growth. We forecast 10% EPS growth between 2010 and 2011. Bottom-up consensus EPS growth equals 14%. Our DDM-based 12-month price target of 1275 implicitly assumes the current NTM P/E multiple remains unchanged at 13.5X. Note that the current multiple equals the average P/E multiple of the S&P 500 during prior periods when real interest rates ranged between 1% and 2% which matches our forecast interest rate environment for 2011.

Three topics drive our view of the trajectory of the US equity market. (1) Sales; (2) profit margins; and (3) money flow. Below we briefly outline how each of these items will be affected by the pending QE2.

1. QE2 is unlikely to change our sales forecasts. Goldman Sachs Economics 2011 US GDP growth forecast already incorporates at least $1 trillion of Treasury purchases by the Fed. Despite the hefty forecast of Fed purchases, our 1.8% GDP growth forecast remains below the consensus expectation of 2.5%. The buy-side seems to be in the 2.0%-2 ¼% range. Our current index and sector-level sales forecasts incorporate our GDP growth assumptions and therefore already capture QE2. Capacity utilization hovers at 74%, up from the March 2009 low of 68% but below the 81% long-term average, so firms are not compelled to fast-track new projects despite the availability of cheap financing. The US has a demand, not a supply, problem. The US Dollar has weakened in the 12 weeks since QE2 entered public debate and it will benefit revenues of US companies, although by less than many investors believe. S&P 500 generates just 30% of sales outside the US.

2. QE2 is unlikely to change our margin forecasts. Our index and sector level net margin estimates incorporate our US and world GDP, interest rate, inflation, oil and US Dollar forecasts and the firm’s macroeconomic view assumes $1 trillion of QE2. If the Fed successfully spurs higher inflation than we currently assume (1.1% in 2011), it will have a negative impact on profit margins because rising input costs will not be fully-passed through to the  consumer. Passing inflation along to the end customer will be particularly difficult in an environment with nearly 10% unemployment. Our 8.4% net margin forecast stands below bottom-up consensus of 9.0%. The Fed’s desire to re-inflate the economy tilts margin risk lower rather than higher. Firms reporting negative margin surprises in 3Q span the value chain from raw (X, AKS, NUE, MEE) to intermediate (GENZ, LLTC, BMS) to end-demand (AN, AVP, KMB, SLB, EFX, AVY, T) to cite just a few examples.

3. Therefore, QE2’s potential impact on the US equity market reduces to a debate over valuation. Bulls argue stocks are dramatically undervalued relative to bonds. It is true that using Treasuries, BBB corporate bonds, or TIPs in the Fed model leads to a conclusion the S&P 500 is 20% undervalued. Bulls similarly argue that QE2 will drive both yields and risk lower,  reduce the cost of equity, and support a DDM valuation above our 12-month target. Bulls implicitly argue stocks should trade at a higher P/E multiple. Our more modest return projection incorporates a current starting point valuation that shows stocks trade at a 13.5x NTM P/E multiple consistent with past real interest rate regimes of 1-2%. However, the current P/E multiple is calculated when margins stand at all-time highs. A P/E assuming normalized margins would be 14.6x closer to the long-term average. We believe the forward path of stocks will be determined by potential asset allocation shifts by owners of 70% of the US equity market. Individuals own in aggregate 53% and pension funds own 17%. Shares will trade sustainably higher if these investor groups decide to re-risk from bonds to stocks. Any shifts most likely will be gradual.


And here are the key charts from Kostin:

A look at sales, earnings, and most importantly, margins:


And Correlation and Risk:

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BeerGoggles's picture

Our year-end 2010 price target for the S&P 500 remains 1200.

Sell signal?

Caviar Emptor's picture

The vicious cycle continues. 

Spending valuable remaining resources so that we can continue to buy more iPads and crap we don't need from China (and send them our offshored jobs). Maintaining corporate welfare for US firms doing business overseas. Supporting US buyers of Korean flat screens, Italian suits, German cars and Saudi oil. Supporting TBTF financial institutions that keep raising their executive pay packages but charge 18% for consumer credit and keep raising fees. And best of all, providing capital that spends 0 time finding its way to emerging markets. 

Somehow, supporting this reckless pattern is the Fed's vision of a vibrant economy. 

That's what's keeping the biflationary vicious cycle alive and well. GS agrees with me that rising input costs can't be passed on to constrained consumers in this economy, eroding margins as we're seeing already with Apple, Proctor and Gamble and 3M this week. Look for further margin erosion. And I think (domestic) sales will disappoint as biflation reduces discretionary income.

snowball777's picture

Imagine what could have happened to the demand side if we'd taken say $1.6T and used it to give everyone in the US $500,000 each instead of these 5 banks and their sycophants.

The banks would get most of it anyway, but they'd be whole and have better reserve levels.

The only real losers would be the servicing industry who would have to find real jobs where they like read the documents they sign and stuff.


buchesky's picture

Except that you would only be able to give each person in the U.S. $5,000 not $500,000 if you had a pot of $1.6T.  Plus, I'm not sure why a massive transfer of wealth from the most productive to the least productive would create growth.  Better to give back the expropriated wealth to the original owners who know how to invest it...

snowball777's picture

investment == productivity. hahahahahahahahaha.

Careless Whisper's picture

since zerohedge has been silent on this topic (could it be those ad revenues from goldman?), here goes;

Feds File 65 Page Motion To Keep Goldman Trial Secret; Need To Protect "Victim's" Trade Secrets That Admittedly "Can Manipulate Markets In Unfair Ways"


and the feds seek to exclude lots of evidence:

In particular, the Government moves to preclude
evidence of the following topics: (1) the financial crisis and
recession; (2) the mortgage market and mortgage securities; (3)
Goldman Sachs’s receipt of funds from the Troubled Asset Relief
Program (“TARP”), or “bailout” funds; (4) the Goldman Sachs bonus
pool, and bonuses and salaries paid to Goldman Sachs employees
generally (as opposed to salaries of programmers or comparable
employees relevant to this case); (5) public statements by
Goldman Sachs executives other than any referring to the subject
matters in this case; (6) civil and regulatory proceedings and
dispositions of matters involving Goldman Sachs, including the
litigation, settlement, and underlying issues in Securities and
Exchange Commission v. Goldman Sachs & Co., no. 10-cv-3229 (BSJ)
(S.D.N.Y. 2010); and (7) investigations of and proposed
regulation of high-frequency trading by the Securities and
Exchange Commission, the Commodities Futures Trading Commission,
and/or any self-regulatory organizations.

and they want to outlaw any evidence of alleged criminal frontrunning using highfrequency trading:

In addition, the legality of highfrequency
trading is not an issue here, and investigations of
high-frequency trading and proposed government regulation is not
probative of the charges in the Indictment.


tom a taxpayer's picture

Thanks, Careless Whisper, for exposing this outrageous example of the govt's misplaced priorities in prosecution, and the govt doing Goldman Sachs dirty work. Instead of prosecuting  Goldman Sachs the most powerful mafia in America, the DOJ is prosecuting a lowly soldier who may have taken one of the mob's secrets to screwing investors. 


What is Kafkaesque is the DOJ is vehemently defending Goldman Sachs secret program to manipulate markets.

RobotTrader's picture

Yet another piece of worthless research from Goldman.

Who much does this Kostin guy get paid?

How many on his staff?

Really, the only thing that matters is price and momentum.

I'm amazed that these guys get paid all this money to come up with these fancy Powerpoint presentations, graphs, charts, data, etc.

None of this crap is going to give him a clue as to where stocks are going.

He doesn't know where stocks are going beyond next week.

I don't either.

But it is not that hard, just follow the meatball on the 15-min. and daily chart, analyze the sentiment readings and that is really all you need to know.


RockyRacoon's picture

At least they generate their own charts -- not posting charts from other sources.

Know anyone like that?

deadhead's picture

How come no "bearish" case for equities from GS.....


Let's see...


USA broke, bankrupt.

states too.

the TBTF banks are near insolvent (read historical info on major bank crises, start with Rogoff and Reinhart's "This Time It's Different".  The MBS fiasco and foreclosurefraudgate are going to strip away many billions in profits/loan loss reserves.

structural unemployment in the u.s.a.

Housing in the USA is dead.

did someone say something about overleveraged consumers


this mess will take years to sort out.  it's a secular bear and, as is usual, the cheat street crowd needs more players to keep the ponzi going.  this movie has played before.

PBRmeASAP's picture

I am Financial Advisor in Upstate NY and all I can tell you is that Smart Retail (You know "the Millionaire Next Door" Types) are re-allocating out of Bonds into Stocks & Real Estate (albeit slowly). 

A typical small business owner with a million bucks in his/her account (50/50 Stock Bond Allocation) is sitting on 50 grand in cap gains in their $500K bond portfolio.... When they take into account that those Bond Cap Gains are going to dis-appear as the Bonds mature at par... they KNOW that their actual YTM based on the current price of the bonds (1-3 %) is in fact lower than the Dividend Yield in their Stock Portfolio...

No Brainer- Dump Bonds into the next round of QE and swap into higher yielding equities. Common Sense and it'll happen.  Slowly dump bonds and buy stocks over the next year or so. Hey ZH friends... Maybe, just Maybe, thinigs will be okay....

Of course all the schmucks in 401(k) land will keep pouring money into bond funds and get creamed... But Upper-Middle Class and above will get the ball rolling again even as rates rise after QE2 ends.

Which is why Goldman is wrong about QE- It will push lots and lots of dough into Equities.


DR's picture

Well this 401k schmuck is pulling out of equities next week. I'll leave it to you and your rich friends to play against the algos....

PBRmeASAP's picture

Well I guess it depends on what your rich definition of rich is!

I'm talking about the local pool-cleaning business owner who works 90 hours a week and lives in a middle class neighborhood, makes 150k a year and has saved some dough over the last 35 years... I don't take Leveraged-McMansion-Owners as clients.

If you pull out of equities in your 401(k), I hope you don't buy long-term bonds!

PBRmeASAP's picture

As to the Algos... well i'm just as pissed of about them as you are... but Great Companies trading at around 11x Earnings, Yielding more than Govt Bonds, with Good balance Sheets?  No Brainer Buys... The Algos will eventually inplode themselves and Sanity will prevail. May take 20 years, I admit! 

mynhair's picture

No gold, bitchez?

Lord Peter Pipsqueak's picture

As far as I can see,current market sentiment has precious little to do with fundamentals such as earnings or P/E's it has however, everything to do with the prospect of QE11 and how first quarter earnings in 2011 turn out and then the prospect for further QE.No it isn't going to end,because Mr Market knows it has the Fed now,it will want QE for perpetuity now just like it has got ZIRP stretching into the horizon.Any sign that QE is going to end or even be curtailed would result in a flash crash of such magnitude that the Fed would be forced to support the market and immediately announce the next stimulus package.SO what would be the point?It may as well just do it upfront and avoid the inevitable "tantrum" the market would throw.It will give the market,like the proverbial spoilt child, exactly what it wants.It has this last week even sent out a "wish list" to the PD's as to how much money they would like them to print up in the forthcoming QE1.The shear fraud and brazen corruption is now entering a phase where they no longer pretend that the government is deciding economic policy any more and don't even try to cover up the transfers to Wall St banks.

If you think QE will end when the Fed sees a pick up in the economy,ask yourself this one question - "when do you think the US economy and the US Govt could afford the interest payments if interest rates rise to just 5%?"

mclee's picture

Can you upload the whole report like you used to be ? Anyways, thank you so much it is useful.

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