The S&P 500 is at its 2012 highs, and rapidly approaching all time highs, even as nothing has changed over the biggest near-term challenge facing America: the fiscal cliff. Ironically, with every tick higher in the market, the probability that Congress will come to a consensus over what would be a haircut of up to 4% to next year's GDP as soon as January 1 2013 gets smaller. Why - the same reason that Spain is unlikely to demand a bailout now that its 10 Year bond is back to the mid 6% range (ironically on expectations it will demand a bailout!): complacency - both by investors, and by politicians. After all, it's is all a matter of perception, and the market is seen to be "perceiving" an all clear signal. It means that the impetus to do something constructive simply does not exist, as we explained recently in the case of Spain (and Italy). It also means that Congress has no reason to be proactive about the biggest threat facing the economy: just look at the S&P - it sure isn't worried, and the market is supposed to be far more efficient than elected politicians. At least on paper. This line of thinking is also the reason why Goldman's head of equity strategy David Kostin (not to be confused with the person he replaced: permabull A Joseph Cohen, who off the record sees the S&P rising to 1600 or more) refuses to raise his year end forecast for the S&P, which has remained firmly at 1250 for the entire year. More muppetry, more dodecatuple reverse psychology, or is Goldman telling the truth? You decide.
From Goldman's David Kostin:
The ‘fiscal cliff’ and downside equity risk: Why we maintain our year-end target of 1250
Why are we maintaining our year-end forecast in spite of the market’s recent rally back above 1400, the positive developments in Europe, and tentative evidence the US economy may be sprouting “green shoots”? A look at the 2011 trading pattern of the S&P 500 explains the reason for our belief that the market has an asymmetric risk profile and offers more downside risk than upside opportunity. Political realities and last year’s precedent suggest the potential that Congress fails to reach agreement in addressing the ‘fiscal cliff’ is greater than what most investors seem to believe based on our client conversations. Scenario analysis in Exhibit 4.
Two of the three pillars of our 2012 framework for analyzing the US equity market have stood firm, but one has not – valuation. Because consensus profit forecasts have been steadily reduced since the start of the year, the positive index returns have stemmed from P/E expansion.
Of our three-part framework, we have the highest conviction in our earnings forecast followed by our economic outlook. We have the lowest confidence in valuation given the number of policy and political variables.
The ECB’s early August promise to provide sufficient funding to prevent the collapse of the Euro coupled with Chancellor Merkel’s supportive comments of ECB policy lowered global risk premiums by thinning the left tail of possible negative outcomes for the European financial system. The resulting P/E expansion explains the 4% surge in S&P 500 during the last two weeks. The index has now advanced 12% YTD and ranks among the top performing bourses in 2012. But P/E multiples can just as easily compress as expand.
Numerous uncertainties exist and any one of them could spark a reversal of the recent equity market rally. Known risks include the US fiscal cliff (federal debt ceiling tax policy, sequestration); US election; China growth; European political, sovereign debt, and bank funding crises; and Iran/Israel tensions. Our year-end 2012 target of 1250 is nearly 12% below the current index level. Why are we maintaining our forecast in spite of the market’s recent rally back above 1400, the positive developments in Europe, and tentative evidence that the domestic economy may be sprouting “green shoots”?
A look at the 2011 trading pattern of the S&P 500 explains the reason for our belief that the market has an asymmetric risk profile and offers more downside than upside. Last year the deadline for Congress to raise the federal debt ceiling was known months in advance. Nevertheless, Congress was unable to reach an agreement that satisfied all factions. Investors were stunned and the S&P 500 plunged 11% in 10 trading days (and more than 17% from the level one month prior to the deadline). Eventually Congress reached a compromise on raising the debt ceiling.
We believe the uncertainty is greater this year than it was 12 months ago. We are in the midst of an acrimonious election season. The likelihood that sitting Representatives and Senators will leave the campaign trail to sit in Washington, DC to negotiate and cast votes on controversial issues involving taxes, unemployment compensation, and sequestration seems remote, in our view. If no agreement on ‘fiscal cliff’ issues is reached before the election, it will require a lame duck Congress to address the topic.
Although the official debt ceiling is likely to be reached in December, Treasury legerdemain will allow the government to be financed under the limit until February 2013, by which point the debt ceiling must be raised.
Political realities and last year’s precedent suggest the potential that Congress fails to reach agreement in addressing the “fiscal cliff” is greater than what most market participants seem to believe based on our client conversations. In our opinion, equity investors seem unduly complacent on this issue. Portfolio managers have been swayed by hope over experience.
What is the downside market risk if Congress does not address the “fiscal cliff”? Goldman Sachs US Economics research estimates that the impact of the fiscal cliff would weigh on real 2013 GDP growth by nearly 4 percentage points if scheduled year-end policy changes were to take effect permanentl. Applying this to our US economists’ forecast, GDP would contract by roughly 0.4% in 2013.
Our current baseline 2013 GDP growth forecast of 2.0% assumes the following: payroll tax cuts expire after 2012, jobless benefits are phased down to a maximum of 59 weeks, income tax cuts are extended through 2013, and automatic spending cuts do not take effect. This fiscal drag represents roughly 1.2 percentage points. Conversely, if everything is extended, the effect of Federal, state, and local fiscal policy on GDP growth would be -0.5 percentage points and 2013 GDP growth would be about 2.7%.
The sensitivity of our sales, margins, and earnings models suggests a 100 basis point shift in 2013 GDP growth rate equals roughly $5 per share in S&P 500 EPS. We currently forecast 2013 EPS of $106. If nothing is done to address the ‘fiscal cliff’ and the US economy contracts by 0.4% the resulting EPS would equal $93, a year over year decline of 6% from $100 of EPS in 2012. Similarly, if everything is extended and the economy expands by 2.7%, then 2013 EPS would equal about $110, reflecting year over year growth of 10%.
Assigning a P/E multiple to various ‘fiscal cliff’ and earnings scenarios is difficult because ultimately we expect Congress will address the situation. But investors must confront the risk they may not act until the final hour. Exhibit 4 contains a matrix of potential year-end 2012 S&P 500 index levels based on different ‘fiscal cliff’ resolutions and multiples. Our 1250 target reflects our ‘fiscal cliff’ assumption and a P/E slightly below 12x. Full expiration with P/E of 12x equals 1120 (-21%). A 14x P/E and full extension implies 1540 (+9%), but the two outcomes are not equally likely in our view.