If on December 31, 2013 someone were to opine that halfway into the second quarter of 2014 the S&P would be largely unchanged on the year, most would laugh at such a statement, expecting either the continued relentless ramp in the S&P (since the global central bank QE still goes on), or the long overdue crash (as it is a question of when not if the Fed finally loses control). Which is why both Goldman and its clients are finally starting to get exasperated:
S&P 500 moved sideways for yet another week, ending virtually unchanged at 1878. Realized volatility has remained low since the start of the year. One-month and three-month S&P 500 return dispersions stand at the 5th and 1st percentile relative to the past 30 years. Individual sector return dispersion also remains extremely low. Simply put, 2014 has been a difficult equity investment environment at both the macro and micro levels.
So in this difficult market, and confusing - for traders, and everyone else - environment, what are the three main questions posed by Goldman's clients had? According to David Kostin, "Three questions dominated our investor dialogue this week given the lack of meaningful data releases.
- Interest rates: The recent decline in ten-year US Treasury yields to 2.6%, the forward path of interest rates, and implications for equity valuation;
- Capex: the outlook for corporate capital spending in 2014; and
- Rotation: The potential for the momentum drawdown of the past two months to reverse and vault high expected sales growth companies back into a market leadership position.
Here are the details from Goldman:
There is no precise answer to why ten-year US Treasury yields have declined by 40 bp since the start of the year to 2.6%. Goldman Sachs interest rate strategy believes the recent yield curve re-shaping is consistent with the downward revision in the US growth and inflation outlook. Realized US GDP growth in 1Q was just 0.1%, well below consensus expectations of nearly 3% at the start of the year. Demand for long-term Treasuries by private pensions may also have been a factor.
Our ‘Sudoku’ bond model suggests ten-year US Treasuries are fairly valued relative to the expected level of short-rates, growth and inflation. Looking ahead, our economists forecast US GDP growth will climb to 3.0% beginning in the current quarter (2Q) while inflation will remain low. Furthermore, growth is anticipated to remain above 3% for the balance of 2014 and throughout 2015, 2016 and 2017. Goldman Sachs forecasts ten-year Treasury yields will rise by 65 bp to 3.25% at the end of 2014 and climb by another 50 bp to 3.75% by end-2015. We expect fed funds will remain unchanged until early 2016. Consensus expects hikes will begin in early 2015.
While the curve flattening, yield compression in long-term rates, and positive 5% YTD return for ten-year notes have certainly surprised most market participants, equities continue to trade around fair value and inline with the path of our forecast. Applying our interest rate estimate to the Fed Model suggests a year-end 2014 S&P 500 target of 1900. With a 16.3% ROE, the index trades at 2.7x price/book value, in-line with the trailing ten-year average and historically consistent with today’s level of profitability. Our 12-month target of 1950 reflects 4% upside from the current level.
Accelerating growth in corporate capital spending is a key component in both our economic forecast and portfolio strategy use of cash analysis. Goldman Sachs Economics expects business fixed investment, which encompasses domestic spending only, to grow by nearly 7% in 2014. Our use of cash analysis suggests S&P 500 capex – which includes domestic and non-US spending – will rise by 9% after slim 2% growth in 2013.
Company guidance on 2014 capital spending plans is consistent with our regression model and forecast. Last year S&P 500 firms spent $649 billion on capex (plus an additional $231 billion in R&D). Nearly 250 firms have provided explicit guidance on their budgeted 2014 capex plans. These stocks accounted for 80% of last year’s aggregate S&P 500 capex. Guidance points to year/year growth of 7%. Capex typically skews towards 4Q. We believe several quarters of 3% GDP growth and 5% year/year sales growth will lead managements to boost spending slightly above current guidance.
‘Indiscriminate selling’ is the phrase that most accurately captures the view of many investors regarding the momentum drawdown since early March. Fund managers argue that the broad sell-off in high expected growth stocks affected some firms that in their view did not merit a de-rating. However, once significant momentum drawdown occurs, the momentum factor is typically not associated with subsequent market leadership although the S&P 500 gains an average of 5% during the next six months. Instead, low momentum, low valuation, and low growth are usually winning factors.
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It may be indiscriminate. But looking at both the post-momentum peak drawdown on both an average and 25%-ile basis, shows that there is still a lot of room for momentum stocks to tumble.