On one hand, it appears that nothing can shake this market which is so controlled by gamma, technicals - and expectations that the Fed will never again allow a correction - that the 4,400 level has proven to be an "incredible anchor."
On the other hand, the big banks are starting to sweat with first Morgan Stanley warning that a 10% correction is imminent, and now Goldman strategist Christian Mueller-Glissmann joining and warning that with 187 days without a 5% drawdown in S&P 500 - one of the longest uninterrupted stretches in the last 100 years - the market is starting to look quite precarious...
... and with "both equities and bonds getting more expensive, multi-asset portfolios are becoming more vulnerable to rates and growth shocks."
While we will get into the details behind Goldman's bearish reversal, the strategist takes a close look at recent ominous moves in inflation indicators, starting with Germany where he notes that last week European breakeven inflation outperformed other ‘procyclical’ assets.
Curiously, the move in breakevens has outpaced that of cyclical vs. defensive equities, which have historically been closely related. To be sure, there appears to be a growing divergence between inflation breakevens and their various historical correlations, with Mueller-Glissmann noting that while in Europe, breakevens have outperformed since Q2...
... in the US they have recovered much faster from the Covid-19 bear market and have increasingly decoupled in 2H with markets fading the reflation trade.
This has been particularly true recently - US cyclicals have closed the week flat vs. defensives despite rising breakevens.
Yet the rise in breakevens has not been mirrored by even more important real rates, and instead as breakeven inflation has risen, it has been accompanied by falling real rates across the term structure...
...and 10-year real rates have reached new lows in both Europe and the US.
Such low levels of real rates, the Goldman strategist warns, "point towards markets pricing stagflation risk, which seems somewhat inconsistent with an economic recovery" that in the view of Goldman economists still broadly on track (despite the bank taking a machete to its 2022 US GDP forecasts) and inflation pressures that should eventually ease, to wit:
At the center of the reflation reversal have been bonds, which have rallied strongly since June with yield curves flattening, pointing not just to concerns of a near-term growth slowdown but the risk of continued secular stagnation in the new cycle as monetary and fiscal support fades. Also, most of the decline in long-dated bond yields has been driven by real yields, with breakeven inflation sticky – that points to growing stagflation concerns.
So with stagflation risk rising, is Goldman turning outright bearish? Of course not: no bank makes money by telling its clients to sell and Goldman is no different. Instead Mueller-Glissman is far more diplomatic, saying that while he remains "pro-risk in our asset allocation into 2H", a view which would by far more justified if US real rates were to push higher - he does caution that "catalysts are likely to be needed for markets to reprice rates higher - a strong jobs report this week might help clarify the trajectory from here", the Goldman strategist warns the "risk of an equity correction has increased" and adds that "the widening gap between S&P 500 returns and changes in bond yields over the past 6 months coupled with very low levels of real yields and elevated equity valuations make equities more vulnerable to both growth and rates shocks."
There were similar equity-bond gaps in 2014, 2016 and 2019, usually after a dovish Fed pivot and all ended poorly for stocks. Incidentally, as we noted previously when discussing the remarkably narrow breadth in the market, the current equity-bond disconnect has been due to the boost to long-duration secular growth stocks - i.e., Amazon, Apple, Microsfot, etc - from declines in real bond yields. This also helped broad indices, which have a larger weight in those stocks. But if and when the "generals" stumble.... watch out.
While Mueller-Glissman jovially inserts that this gap might "linger for longer" or close in a "friendly" way, with bond yields gradually increasing, such an event is unlikely and the risk of a correction in the event of either a rate shock or a growth shock has increased. Just look at the recent past when we had a similar outcome in 2015 with the China growth shocks and in 2020 with the COVID-19 shock; indeed, only in 2016 did the gap close with the bond sell-off and higher equities post the election of President Trump. So fast forward to today when not only is the current rally without even a 5% drawdown one of the longest in the past decade, but as Goldman warns, "valuations for US growth stocks have expanded significantly again and are back to last year's highs "
There's more. The strategist then lists several other reasons behind the bank's increasingly bearish view, starting with the recent plunge in Goldman's Risk Appetite Indicator (which we flagged two weeks ago)...
... and whose current level Mueller-Glissman says is consistent with an ISM manufacturing index in the low 50s.
The Goldman strategist then looks at various popular factors and notes that while cyclicals vs. defensives have reversed little of their COVID-19 recovery performance, the moves have been more about value vs. growth, EM vs. DM and financials vs. staples.
This according to Goldman, highlights that investors are "not necessarily repricing the near-term growth outlook but more a worsening medium-term growth inflation mix in a post-COVID world. In the last few days the RAI has started to pick up but this was mainly due to a reset in the volatility components – across the other assets, there is little sign of a reversal."
One more observation on Goldman's Risk Appetite Indicator: peeking under the hood at the index components shows that growth optimism (RAI PC1) remains under pressure and is close to zero.
This means that while backward-looking earnings seasons in Europe and the US have generally been strong, "markets still appear unconvinced that there will be more positive growth impulses into year-end and the new cycle, with US fiscal stimulus starting to disappoint and drags on consumption from COVID disruptions."
Almost as if the market demands another stimulus... and is well aware that to get that, another round of
Code Red lockdowns will have to be ordered.
There is another reason why Goldman is turning skeptical: "elevated equity valuations coupled with a worsening growth/inflation mix increase equity drawdown risk." As Mueller-Glissmann points out, "while valuations alone are not a good signal for market timing, combining them with information about the macro backdrop helps assess equity drawdown risk better. One way to combine the signals is a logit model that relates the risk of a 10% S&P 500 drawdown over the next 12 months to levels of Shiller P/E and growth or realized volatility as an indicator of the macro backdrop."
And this is where Goldman and Morgan Stanley agrees: as the bank's strategist writes, "currently, a purely valuation-based signal indicates somewhat elevated risk of a 10% drawdown, which is not surprising with equity valuations nearing Tech Bubble levels."
With all that, Goldman's advice to clients is simple: "look at equity correction hedges or ways to reduce equity risk in the near term."
As we recently wrote, option markets are pricing higher equity drawdown risk than normal during an ISM slowdown phase, with particularly large left tails – S&P 500 put skew and other convexity risk premia in equities are at multi-decades highs, reflecting investor concerns about sharp and large drawdowns. We continue to like shorter-dated put spreads which, with elevated skew, can offer cheaper correction hedges – they look particularly attractive in Europe
To this all we can add is that since Goldman tends to always be wrong, the very fact that the most important investment bank in the world is telling its clients to brace for a correction is why the S&P may continue levitating without a 5% correction for years to come...