Goldman On Why Things Will Get Worse Before They Get Better And Gives An S&P Target If The Eurozone Breaks Up

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In his latest weekly chartology, Goldman's David Kostin takes a different route to recapping the week's events and instead of merely summarizing the market action, explains what the views of Goldman's clients are, especially the bulls among them ("Bullish investors hold more positive outlooks for margins and Europe, and argue that our target is too low. Some investors generally agree with our muted outlook for the economy and corporate earnings, but feel that an agreement to end Europe’s debt crisis will inevitably be reached next year. They argue that the stabilization of sovereign balance sheets, recapitalization of European banks, and clarity in the region’s future will cause a surge in investor confidence. Investors commonly quote 1400 as a target S&P 500 price level in this “risk-on” scenario of multiple-expansion.") and then juxtaposes to its why Goldman continues to be bearish: "We expect the situation to worsen before it gets better with market pressure necessary for progress. EU Summit demonstrates progress but lacked “regime change.” Overall, policymakers are making progress and signaled a commitment to address the twin sovereign and banking system crises. However, lack of clarity on the IMF’s role and no clear change in the ECB’s activities in sovereign debt markets will likely leave some investors disappointed." Which is precisely what we have been claiming for weeks - that unlike the other banks who are preaching rosy outlooks out of sheer terror for what a European crash would mean for them, Goldman is hoping it comes quickly, so that ostensibly several big banks can blow up, and the ECB steps in forceefully but not before Goldman's extended web of control in political Europe allows it to step into the void and become a major market presence on the continent.

Two other points of observation: Goldman highlights where the core difference between its forecast and that of the rest of the street is: " we expect margins to contract to 8.7% in 2012 from 8.9% in 2011 while consensus expects them to grow to 9.4%. Each 50 bp shift in margins equals about $4 in S&P 500 EPS." and also presents an outlook on the eurozone's collapse that does not share the self-serving view of UBS which calls for people to hoard dry food and weapons: "Fear of euro collapse frames more bearish views. A small minority of investors expects a euro breakup and a deep recession in Europe. In this case our uncertainty-based P/E model suggests the S&P 500 could fall by roughly 25% to 900. Even if collapse is avoided, the continuation of “passive containment” and delay of resolution continues to raise the costs in both financial and economic terms, creating a poor condition for equity markets."

Full note highlights:

This week we met with a wide range of investors to discuss the outlook for US equities in 2012. Roughly two thirds of the clients we met with agree with our base case view that the S&P 500 will deliver lackluster returns next year. Among those that do not, Europe is the key factor with bulls outnumbering bears. Investors with global or cross-asset mandates broadly see US equities as attractive in relative terms. Our outlook is based on three central points: 

 

1. Stagnant economy. Our US economics team expects a fifth straight year of sub-trend economic growth with 1.6% GDP growth forecast in 2012 and the environment persisting in 2013 with 2.2%. They expect unemployment to remain elevated at 9%, fiscal drag from a divided Congress, and restrained capex in the face of political and economic uncertainty. 

 

2. Modest earnings growth. We expect margins to peak in 2011 and fall slightly in 2012. Combined with weak sales growth, this means S&P 500 earnings should grow only 3% to $100 in 2012. Consensus expects $108. 

 

3. Stable valuation. P/E multiples tended to remain flat during 17 “stagnation” periods of prolonged weak but positive economic growth in OECD countries since 1980. A flat P/E of roughly 12x is supported by our dividend discount model and uncertainty-based P/E model, although other approaches such as the Fed model and the historical ROE vs. price/book relationship suggest significant upside to fair value. Flat valuation along with modest earnings growth translates into our S&P 500 year-end 2012 target of 1250, roughly unchanged from the current level. 

 

For clients who agree with our outlook, we recommend three strategies involving our thematic baskets. Buy: (1) High Quality Stocks (Bloomberg ticker: <GSTHQUAL>) with safe balance sheets and a history of stable growth; (2) Dividend Growth and Yield (<GSTHDIVG>) as investors navigate an environment of weak price returns and low yields; (3) stocks with high US sales exposure vs. firms with high international revenues (<GSTHAINT> vs. <GSTHINTL>). These strategies have generally outperformed in 2011 and should continue to work in 2012 given our outlook. Stocks that appear in at least two of these baskets include ACN, OXY, WAG, CTL, JPM, and WFC. 

 

Bullish investors hold more positive outlooks for margins and Europe, and argue that our target is too low. Some investors generally agree with our muted outlook for the economy and corporate earnings, but feel that an agreement to end Europe’s debt crisis will inevitably be reached next year.

 

They argue that the stabilization of sovereign balance sheets, recapitalization of European banks, and clarity in the region’s future will cause a surge in investor confidence. Investors commonly quote 1400 as a target S&P 500 price level in this “risk-on” scenario of multiple-expansion.

 

The divergence between this view and our own is the path to resolution. Bulls expect clarity in the near term that will reassure investors. We expect the situation to worsen before it gets better with market pressure necessary for progress. Our global equity forecasts point to 3- and 6-month downside in Europe, Asia and the US before recovery in 2H 2012. Clients with global or cross-asset mandates broadly see equities as attractive relative to low bond yields and the US as appealing globally due to recent growth momentum.

 

EU Summit demonstrates progress but lacked “regime change.” Overall, policymakers are making progress and signaled a commitment to address the twin sovereign and banking system crises. However, lack of clarity on the IMF’s role and no clear change in the ECB’s activities in sovereign debt markets will likely leave some investors disappointed.

 

Others who disagree with our forecast argue that margins will continue to expand as sales grow, even in a sub-trend economic environment.

 

However, history shows that margins don’t always expand when sales grow. During the last 40 years S&P 500 margins have hit cycle peaks and contracted six times, and in each period sales continued to grow. Rather, margins tend to contract in periods of positive but decelerating sales growth.

 

We expect significantly slower sales growth in 2012 than the 11% rate in 2011, as does consensus. 

 

Margins are the key difference between our earnings forecast and the consensus view for 2012. We have similar expectations for sales growth in 2012 at 3.7% vs. 5.1% for consensus (ex-Financials and Utilities). However, we expect margins to contract to 8.7% in 2012 from 8.9% in 2011 while consensus expects them to grow to 9.4%. Each 50 bp shift in margins equals about $4 in S&P 500 EPS. The 70 bp gap between our margin forecast and consensus explains 75% of the $8 difference in 2012 EPS estimates.

 

Fear of euro collapse frames more bearish views. A small minority of investors expects a euro breakup and a deep recession in Europe. In this case our uncertainty-based P/E model suggests the S&P 500 could fall by roughly 25% to 900. Even if collapse is avoided, the continuation of “passive containment” and delay of resolution continues to raise the costs in both financial and economic terms, creating a poor condition for equity markets.

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