At the beginning of the year, all - as in all - of the smart money expected a rising yield environment and a recovering economy. They were all wrong. Oddly enough, they still believe pretty much the same, using seasonal scapegoats to explain away their mistakes. As for what the most selective subset of the smart money believes, here is Goldman's David Kostin with the summary: "Almost all clients have the same outlook: 3% economic growth, rising earnings, rising bond yields, and a rising equity market." Goldman's own view doesn't stray much: "Our S&P 500 targets of 1900/2100/2200 for end-2014/2015/2016 are slightly more conservative but generally in line with consensus views." And of course, when everyone expects the same, the opposite happens... even if this is one of those financial cliches we wrote about yesterday [8].
More observations on Groupthink 101 from Goldman:
This week we met with a large cross section of our institutional clients and everyone agrees with the following consensus outlook: (1) the US economy will reaccelerate to a 3%+ GDP growth rate beginning in the current quarter; (2) S&P 500 earnings per share will rise by roughly 8% to $116; and (3) the US equity market currently trades around fair value.
S&P 500 has advanced 4% YTD and stands at an all-time high of 1920. Our multi-year S&P 500 targets remain 1900 at year-end 2014 (-1% versus
today), 2100 at the end of 2015 (+9%), and 2200 at the end of 2016 (+15%). Most clients agree with our outlook of rising US equity markets but expect the targets will be reached sooner than we anticipate, in many cases by about 12 months. If S&P 500 climbs to 2100 by the end of this year and bottom-up earnings converge to our top-down forecast, the market will have a bottom-up forward P/E of 16.8x vs. 15.7x today.
Clients also have a consensus outlook for the bond market. Although interest rates have confounded most fund managers this year with 10-year Treasury yields falling from 3.0% to 2.4%, investors uniformly expect rates will rise by year-end 2014. Most cite a target of 3.0% to 3.25%. According to Consensus Economics, disagreement about rates is low relative to postcrisis history. The mean 12-month expectation for 10-year Treasury yields equals 3.5%, with a standard deviation of 27 bp. With the exception of a few outliers, almost all estimates fall between 3.4% and 3.8%.
Ten-year US Treasury yields are at the lowest level in nearly a year. Debate exists whether the 2.4% yield reflects (1) weak 1Q GDP, (2) shortage of AAA-rated assets, or (3) a deteriorating long-term economic outlook. Regardless of the reason, measures of implied interest rate volatility suggest low uncertainty and dispersion about current interest rate levels. Our bond strategists continue to forecast a 3.25% yield by year-end 2014.
The ultimate reason for the fall in yields does have implications for our medium-term equity outlook. If rates are lower due to a growth soft-patch or thanks to supply/demand imbalances there is a benign, and perhaps even positive, impact on the stock market as growth improves. However, risks to long-term growth would outweigh any short-term benefit from lower yields. In terms of the economic outlook, minimal difference exists between Goldman Sachs US Economics GDP forecast and consensus. We forecast 2Q annualized GDP growth rate will surge to 3.7%, up from -1.0% in 1Q, and growth will exceed 3% during the balance of 2014 and in 2015. Consensus expects 2Q growth of 3.5% and growth of 2.5% in 2014 and 3.0% in 2015.
In terms of profit growth, our forecasts of sales, margins, and earnings are close to bottom-up consensus estimates. Our top-down model forecasts 2014 year/year revenue growth of 6% compared with consensus of 5%. We anticipate flat margins of 8.9% this year while analysts expect margins will climb to 9.3%. However, from an EPS perspective, our top-down 2014 forecast of $116 per share is nearly in line with the bottom-up consensus of $117. Our 2015 forecast of $125 is slightly below consensus of $130. That difference stems from a nearly 100 bp gap in margin views (we expect 9.0% vs. consensus of 9.9%). Information Technology is the key sector to watch.
In terms of valuation, most of the metrics we use suggest the S&P 500 trades around, if not slightly above, fair value. In aggregate, S&P 500 trades at 15.7x forward 12-month EPS, above the 35-year average, and at 17.7x trailing EPS, about one turn above the average trailing P/E since 1921. The median stock trades at 16.9x forward earnings which is more than one standard deviation above the long-term average.
Other valuation metrics such as the Shiller cyclically-adjusted P/E ratio suggest the market is 30%-45% overvalued while our Normalized EPS framework suggests a more modest 10% premium to fair value. Valuation approaches based on interest rates (both real and nominal) lead us to the similar conclusion using either Treasury or corporate bond yields.
The constructive consensus outlook for the equity market masks the fact that 2014 has been an extremely difficult stock picking environment. As noted previously, dispersion of returns across the S&P 500 and within sectors ranks in the first percentile relative to the past 30 years. In addition weak performance in Consumer Discretionary and strong returns in Utilities run counter to the positioning of mutual funds and hedge funds. Both sector performance and dispersion have improved very modestly over the past two weeks, offering some hope.
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