Well, technically, Goldman clients are asking if they should be buying anything at all, period, in a time of resurgent volatility driven by rising rates and bond market vol, which sparked a high beta/growth panic in equities two weeks ago but have since seen the influence fade.
For those who missed last week's rollercoaster, Goldman recaps it as follows: "10-year Treasury yields jumped 20 bps last week, retreated by 10 bp, and then reversed that decline to end this week at a new 12-month high of 1.62%." Yet despite this latest spike in rates, the VIX tumbled with stocks rising to all time highs, even though Treasury implied volatility is now at the highest level since last March, according to the SRVIX index...
... and almost there according to the MOVE index.
Yet anyone hoping for a quick and painless reprieve from surging rates will be disappointed. In his latest Weekly Kickstart, Goldman's David Kostin writes that the bank's economists expect that rates will continue to rise in coming months and forecast 11% real US GDP growth in 2Q with core PCE inflation rising to 2.3% "suggesting that investors will have to continually grapple with the anxiety about economic overheating and Fed tightening that has gripped markets in recent weeks." Goldman also expects the 10-year yield will rise to 1.8% by mid-year and 1.9% by year-end. At the rate it is going, it may get there next week.
This is a big problem for Goldman because while we already know that equities are extremely overpriced according to most valuation metrics, with the S&P 500 trading above the 90th percentile in absolute valuation...
... and prompting Goldman clients to ask what - if anything - is still cheap, Kostin responds that stocks are "only" in the 40th percentile relative to interest rates. Which is a problem if rates continue to rise as the only metric on which stocks are cheap will soon suggest they are not that cheap when compared to rates.
So, to ease client nerves, Kostin writes that in his view "equity valuations should be able to digest 10-year yields of roughly 2% without much difficulty" assuming of course, that the move higher in real yields is slow and contained, something it wasn't in recent weeks when the surge in real yields was a 2+ std dev event. In fact, it is safe to say that no move higher in yields will ever be contained and organized with trillions in AUM on the verge of panic liquidation any time 10Y yield spikes.
Still, even if the 10-year yield hits 2% against a constant S&P 500 forward EPS yield of 4.5% (the inverse of a 22x P/E multiple) that would reduce the yield gap between stocks and bonds to approximately its 45-year average of 250 bp, neither rich nor cheap.
So what else do Goldman's clients think? Well, based on Kostin's client conversations, most investors share the bank's view that interest rates will continue rise, but many believe that the equity market rotations that have recently accompanied rising rates have gone too far. Translation: Goldman clients are desperately trying to convince nobody but themselves that the turmoil is over (spoiler alert: it is only just starting).
Still, the last month has indeed been a nightmare for most investors as nothing - both value stocks and cryptos - seemed to work. Consider that Goldman's sector-neutral long/short growth factor declined by 12% during the past month, the largest 1-month decline in its history since 1980. At the same time, the 4-month stretch of Value factor outperformance since the vaccine efficacy announcements in November matches the average length of Value rotations since the Financial Crisis, the factor’s 30% recent rise rivals two of the decade’s largest Value rallies, in 2013 and 2016.
But what may be even more challenging is that value no longer is cheap as it was just a few weeks ago. Specifically, Kostin notes that this week Goldman's equity analysts’ proprietary Reopening Scale climbed to a 5 on a scale of 1 to 10...
... even as the bank's Reopening basket has already recovered 75% of its decline, suggesting markets have vastly outrun the recovery. Consider that Goldman's Cyclicals vs. Defensives basket pair has climbed to its highest level since the post-tax reform surge of early 2018...
... and the relative P/E valuation of the baskets stands at its highest historical level outside of the post-GFC recovery.
So with many cyclicals and “reopening” stocks no longer trading at depressed levels, and with growth stocks susceptible to further market turmoil on the back of rising rates, Goldman's clients ask: “Where is there still value in the US stock market?”
Well, since Goldman makes its money by making markets, and has a sworn duty to encourage clients to buy cheap stocks even when there aren't, Kostin answers with a decisive yes.
Starting at the top of the list, the Goldman strategist writes that at a factor level, “Value” still looks very attractive relative to history.The P/E multiple gap between the highest valuation and lowest valuation S&P 500 stocks, on a sector-neutral basis, registered 231% at the start of 2021, the highest level since 2000. That spread has since declined to 161% but is still substantially above its 40-year average of 103%
Kostin has some more good news for value investors: "as rates rise and growth accelerates, Value should continue to outperform. High dividend yield stocks, a close cousin of Value, look particularly depressed."
As a result, at a macro level, S&P 500 dividend futures "also still appear to present an attractive value, with the 2023 contract trading 11% below our top-down forecast and only 5% above realized 2019 payments. "
A second curious observation is that "surprisingly, the valuation of the S&P 500 Info Tech sector also registers below its historical average relative to the broad index." As we have documented for the past 4 weeks, much recent investor focus –and portfolio pain –has been concentrated in the longest-duration stocks with attractive long-term growth prospects but weak current profitability. Long-duration equities are particularly sensitive to rising rates, as evidenced by the 13% decline of our new Long Duration basket during the past month.
Goldman's Short Duration basket (GSTHSDUR) rallied by 12% during the same time. However, there is a large difference between the profitability and valuations of S&P 500 Info Tech and stocks like those in our Non-Profitable Tech basket (GSXUNPTC). Tech’s current 16% P/E premium to the S&P 500 is actually lower than the 40-year average of 32% (29% excluding 1998-2002). One further bullish case for growth stocks: as rates rise, near-term growth and profitability become more valuable; these are strengths of many large-cap tech firms (of course, if rates rise too far too fast, growth stocks will be crushed regardless)
Third, Kostin notes that some of his favorite current thematic investment strategies also remain attractively valued in relative terms despite sharp recent appreciation:
Our Low Labor Cost basket has outperformed the S&P 500 by 800 bp in the past six weeks (14% vs. 6%) but still trades at an 17x forward P/E, representing a 20% discount to the S&P 500. Our High Operating Leverage basket trades at the same P/E as the S&P 500, but has averaged a 7% premium during the past decade. Both baskets should outperform as the economy improves and unemployment falls.
Still, not even Kostin can say that the market as a whole is anything but extremely overpriced, and admits that "In absolute terms, most of the US equity market carries above-average valuations relative to history.This is unsurprising with the S&P 500 trading at 22x NTM P/E (96th percentile)" (see chart above). In fact, the Goldman strategist admits that valuations today are even more elevated than they were in 2000. 20 years ago, the aggregate S&P 500 P/E was a similar 24x, but the median stock traded at 14x. Today, the median firm trades at 21x.
A breakdown by sector reveals that the recently hammered defensive industries generally trade at the lowest valuations in the market today, while Consumer Staples, Communication Services, and Health Care trade at the lowest valuations relative to their own histories and vs. the S&P 500. And while Goldman admits that Defensives should carry a discount in an economic environment of improving growth and rising rates, the bank believes that Health Care stands out as an attractive longer-term opportunity. Relative to other “bond proxy” sectors, Health Care generates much stronger EPS growth and has historically exhibited less interest rate sensitivity: "The sector’s current 23% FY2 P/E discount to the S&P 500 matches the largest discount in our 45-year data history, and like other comparable historical episodes is likely explained by an over-abundance of political uncertainty."
Finally, and extending on a point he made last week, Kostin writes that Goldman's macro forecasts also suggest that two of the most quintessential value sectors can still appreciate in coming months despite being the strongest recent performers in the market.
Case in point, Energy - which we have been pounding the table on since last summer (see the Exxon posts) - has returned 40% YTD and continues to trade with a very close relationship to long-term oil prices. Goldman's commodity strategists expect Brent crude will rise 8% to $75/bbl next year. Energy is also the only S&P 500 sector with short interest above its historical average. This will be key once Quants (which recently covered their energy shorts) go massively long the energy sector as we previewed on Friday. Similarly, Financials, the second best sector YTD (16%), trades closely with Treasury yields. Although it has recently rallied more than its typical relationship with rates would have implied, relative valuations remain low compared to history and Goldman expects value to keep outperforming if the economy continues to accelerate and rates continue to rise.