Goldman's equity strategist David Kostin has been very quiet for the past year, having not budged on his 2012 year end S&P target of 1250 since late 2011. Today, he finally released a revised forecast, one that curious still leaves the year end forecast unchanged at a level over 200 points lower in the S&P cash, and thus assuming a ~15% decline. The reason: the same fiscal cliff (which would otherwise deduct 5% in GDP growth) and debt ceiling debate we have warned will get the same market treatment as it did in August of 2011 when the only catalyst was a 15% S&P plunge and a downgrade of the US credit rating. However, one the fiscal situation is fixed, Kostin sees only upside, with a 6 month target of 1450 ("We raise our medium-term fair value estimates for the S&P 500 in response to openended quantitative easing (QE) announced by the Fed."), and a year end S&P target of 1575, calculated by applying a 13.9 multiple to the firm's EPS forecast of 114. Of course, this being bizarro Goldman Sachs it means expect a continued surge into year end, then prolonged fizzle into the new year. Why? Because there is not a snowball's chance in hell the consolidated S&P earnings can grow at this rate, especially not if the Fiscal Cliff compromise is one that does take away more than 1% of GDP thus offsetting all the "benefit" from QE.
Simply said, companies who have already eliminated all the fat, and most of the muscle, and are desperate for revenue growth to generate incremental EPS increase, have not invested in CapEx at nearly the rate needed to maintain revenue growth (see How The Fed's Visible Hand Is Forcing Corporate Cash Mismanagement) having dumped all the cash instead in such short-sighted initiatives as dividends and buybacks. Also, recalling that revenues are now outright declining on a year over year basis, and one can see why anyone assuming a 14% increase in earnings in one year, is merely doing all they can to make the work of their flow desk easier.
Equities are attractive for long-term investors but face near-term risks. We forecast S&P 500 will reach 1575 at year-end 2013 based on our new 2014 EPS estimate of $114 and a fair value P/E of 13.9X. The FOMC’s open-ended easing program allows investors to look past current stagnant economic growth and focus on corporate fundamentals. So far QE has reduced the equity risk premium but not yet improved growth expectations. However, in the near-term we apply a valuation discount due to fiscal policy uncertainty. Our year-end 2012 price target remains 1250
- Downside risk through year-end stems from ‘fiscal cliff’ uncertainty Investors are too complacent that Congress reaches compromise on the divisive issues of taxes and spending during the six weeks between the Nov 6 election and Jan 1 when $576 billion of fiscal contraction starts.
- New QE policy supports rising EPS in 2014 and the market will follow Although Congress may stumble, we assume it reaches agreement in early 2013 to delay full impact of the ‘fiscal cliff’. Open-ended QE has eased financial conditions and will continue to support GDP growth. We raise our 2013 S&P 500 EPS estimate to $107 and introduce a 2014 estimate of $114.
- S&P 500 will establish a new high of 1575 at year-end 2013 We forecast S&P 500 will reach 1575 by year-end 2013, 9% above current and 1% above the 2007 peak. Once policy risks are addressed investors can focus on the trajectory of EPS growth, high ROE, and valuation metrics.
We apply a valuation discount to S&P 500 through year-end due to fiscal policy risks but see attractive upside over the medium-to long-term. Open-ended QE allows investors to look past current stagnant economic growth and assign valuation consistent with strong fundamentals. We introduce a 2014 EPS estimate of $114 and a year-end 2013 S&P 500 target of 1575 but maintain our 2012 year-end target of 1250.
Two of the three pillars of our 2012 framework for analyzing the US equity market have stood firm, but one has not – valuation. US GDP growth has been below trend at 2% and our top-down 2012 S&P 500 EPS estimate has remained unchanged at $100 since the start of the year. Meanwhile, consensus sales and earnings estimates have dropped by 1% and 5%, respectively, since early 2012. Despite that, valuation is notably higher.
Our expectation that S&P 500 valuation would remain flat in 2012 in the face of stagnating economic and earnings growth has been incorrect. Investor response to Fed and ECB policy actions since June 2012 was far more dramatic than we anticipated. The forward P/E multiple has expanded by 15% to 13.4x and S&P 500 has advanced by 15% YTD, reversing the pattern of 2011 when EPS rose by 15% but S&P 500 ended flat at 1258.
We raise our medium-term fair value estimates for the S&P 500 in response to openended quantitative easing (QE) announced by the Fed. The FOMC’s commitment to pursue a loose monetary policy until unemployment falls should allow investors to look through the current period of stagnation and assign a valuation multiple consistent with corporate fundamentals, once fiscal policy risk abates.
Our S&P 500 price targets are 1250 at year-end, 1450 in 6 months and 1575 at yearend 2013. Those estimates suggest returns of -14%, 0%, and +9% over those time periods. Our year-end 2012 forecast is below our estimate of fair value due to high uncertainty from the impending December 31 ‘fiscal cliff’.
Our baseline assumption is that fiscal issues will be resolved during 1Q 2013 but they remain the largest medium-term risk to US equity performance and economic growth. Our US Economists expect $193 billion of fiscal consolidation out of the potential $576 billion total, representing a drag of about 120 bp on 2013 GDP.
Although we forecast a rising stock market in 2013, numerous headwinds remain for equity performance that policy action must overcome: Consensus 2013 EPS estimates remain too high despite sales and EPS revisions that have been consistently negative in 2012; S&P 500 margins have declined for three quarters; US GDP growth continues to stagnate near 2%; China economic growth has been reduced ahead of an important political transition in November; and political and policy uncertainty remains high in Europe along with risk to Euro area growth. The major near-term policy risk relates to possible 1Q 2013 fiscal consolidation of roughly 4% of GDP under a worst case outcome.
Our S&P 500 EPS, revenue and ROE estimates remain largely unchanged as QE was already an element of our US GDP forecasts. We expect S&P 500 will earn $100 per share in 2012, $107 in 2013 and $114 in 2014, with revenue growth of approximately 5% in each year. Our ROE forecasts remain 17.5% for 2012 and 17.3% for 2013 for the S&P 500 due to weak Financials ROE but 19.7% and 20.7% on an ex-Financials basis.
Slow growth, low inflation and high unemployment justify additional easing. Goldman Sachs US Economics forecasts real US GDP growth of 2.2% in 2012 and 1.9% in 2013. They forecast benign core PCE inflation below 2% and expect the US unemployment rate will remain above 8%. Our forecasts are modestly more conservative than the FOMC central tendency outlook as well as consensus expectations. We assume GDP growth of 2.5% in 2014 as an input in our top-down sales, margin, and EPS.
We revise our 2013 S&P 500 earnings estimate to $107 (from $106) and introduce a 2014 EPS forecast of $114 per share. Our new estimates imply EPS growth of 4% in 2012, 7% in 2013, and 6% in 2014. Our EPS estimates are below current bottom-up consensus EPS estimates in 2012, 2013 and 2014 of $102, $115 and $128, respectively (see Exhibit 1).
Our regression-based model of sales and net margins for each sector drives our earnings forecasts for individual sectors and for the overall S&P 500. Variables included in our sales and margin models encompass US GDP growth, world GDP growth, 2-year and 10- year US Treasury rates, Brent crude oil, core inflation, and the tradeweighted US Dollar (see Appendix A for our macroeconomic assumptions).
The level of sales is highly correlated with nominal economic growth. We assume the nominal size of the US economy will grow by 3.7% in 2013 and by 4.6% in 2014. Given more than 30% of aggregate revenues of S&P 500 companies take place outside of the US, our model forecasts S&P 500 sales will rise by 4.4% in 2013 and 4.7% in 2014, respectively.
Our revenue growth forecast is in-line with consensus expectations. We forecast trailing four quarter net margins will return to the previous peak of 8.9% by 2013 before rising to a new peak of 9.0% in 2014. Higher labor costs and decelerating margin expansion in the Information Technology sector are headwinds to further margin expansion at the index-level (see Exhibit 4). Consensus expects aggressive margin expansion of 60bp in both 2013 and 2014. Bottom-up consensus forecasts S&P 500 margins will reach new peak levels by 1Q 2013.
To summarize: Goldman rejoins the sellside groupthink. It will be wrong once again.