One month after Goldman strategists downgraded equities to neutral on growth and valuation concerns back in May, the firm turned up the heat on the bearish case with a June report by Christian Mueller-Glissmann, in which the Goldman strategist said that equity drawdown risk “appears elevated” with S&P 500 trading near record high, valuations stretched, lackluster economic growth and yield investors being “forced up the risk curve to equities." Specifically Goldman warned to prepare for a "major drawdown."
We, however, were skeptical, and concluded our take on Goldman's newfound skepticism as follows: "we can't help but be concerned that the last time Goldman warned about a big drop in the market a month ago, precisely the opposite happened. Will Goldman finally get this one right, or did the firm just say the magic words for the next leg higher in stocks? "
Well, Goldman was right about a brief "drawdown" in stocks just a few weeks later following the Brexit swoon, which however on the back on unprecedented central bank verbal support, resulted in one of the biggest rallies yet, not to mention a historic short squeeze, and indeed led to the next leg higher in stocks, to fresh all time highs to be precise.
So for those who believe that Goldman is just another incarnation of Dennis Gartman and are still bearish, you may want to close out any remaining short positions because moments ago, the same Christian Mueller-Glissman released a new report in which Goldman has gone outright bearish, with a "tactical downgrade to equities for the next 3 months."
Here is the reasoning behind Goldman's creeping sense of gloom:
- The rally in risky assets over the past few weeks has continued n and broadened – the S&P 500 has made all-time highs, the VIX has fallen, bonds and ‘safe havens’ started to sell off, and cyclicals have outperformed defensives.
- We think a key driver of the recovery has been a combination of the light positioning into Brexit and the search for yield amid expectations of easing.
- However, given equities remain expensive and earnings growth is poor, in our view equities are now just at the upper end of their ‘fat and flat’ range.
- Our risk appetite indicator is near neutral levels and its positive momentum has faded, suggesting positioning will give less support and we will need better macro fundamentals or stimulus to keep the risk rally going, but market expectations are already dovish and growth pick-up should take time.
- As a result, we downgrade equities tactically to Underweight over 3 months, but remain Neutral over 12 months. We remain Overweight cash and would look for resets lower in equities to add positions.
First off, in its attempt to skim over its most recent erroneous call, Goldman's global risk appetite indicator "signalled a persistent lack of risk appetite ahead of Brexit (and in general since 2015), with our indicator mostly negative, and a sharp decline post the Brexit vote. The lack of positioning was a key reason why we decided to stay Neutral on equities despite the quick relief rally. Since then, our risk appetite indicator has increased further, indicating a continuation of the risk appetite reversal. We think the negative asymmetry in risky assets is increasing again. A positive level of the risk appetite indicator is not a bearish signal per se – the indicator can remain in positive territory for prolonged periods of time without any risk of drawdowns as long as macro fundamentals remain supportive. However, with our risk appetite indicator now in neutral territory, the market is more vulnerable to growth and policy disappointments, in our view. In addition, its positive momentum has faded and we are back at the levels we saw ahead of the last 3 drawdowns."
Goldman adds the following:
While the initial risk appetite reversal had both risky and ‘risk-off’ assets rallying alongside each other in a strong search for yield, a more reflationary rally has occurred since July 8, during which bonds and other ‘risk-off’ assets such as gold and the Yen started to sell off, up until Friday. Alongside this, cyclicals and financials outperformed, while low vol stocks underperformed (Exhibit 3). The cyclicals vs. defensives roundtrip, for example, has happened across regions (Exhibit 4) and has been particularly strong in EM and Japan (supported by the financials’ rally after the recent BoJ decision), but we believe a large part of the reversal is now done and without a sustained pick-up in growth, the more pro-cyclical rally is running out of steam.
In short, Goldman's doubling down on a bearish forecast have nothing to do with a change in fundamentals (which have not improved according to the firm) and everything to do with a shift in sentiment and positioning. To wit:
We think this reversal in positioning increases the likelihood of an equity pullback given that our fundamental view has not changed: valuations still appear high and we still expect poor earnings growth across regions. In our view, equities remain in their ‘fat and flat’ range and are now just near the upper end. As a result, we downgrade equities to Underweight in our 3-month asset allocation. Until the growth situation improves, we are not that constructive on equities, particularly after this type of rally and amid continuing concerns about the sustainability of stimulusled growth in China, global policy uncertainty (and in Europe in particular), dovish central bank expectations, and heightened prospects of unknown shocks (e.g. Turkey recently). We remain Overweight credit, which has less negative asymmetry than equities, in our view.
So, if one believes that Goldman is going to be right this time, how should one trade the coming risk asset swoon? Some ideas from the taxpayer-backed hedge fund:
Cross-asset volatility has reset significantly lower, particularly relative to where recent realised levels are.
We remain Overweight cash over 3 months to benefit from a pick-up in volatility and look for opportunities to re-enter upon pullbacks in equity, as we remain Neutral over 12 months. We think the negative asymmetry for risky assets and for bonds could require more aggressive risk management. We highlight the following cross-asset opportunities:
- Call-overwriting across indices
- Short-dated S&P 500 options: Long OTM calls for investors worried about a squeeze higher, long puts for hedges
- Long-dated Nikkei vol
- Long gold vol
- Long MSCI EM puts to hedge positions
Finally some thoughts from Goldman on the underlying macro situation...
Macro surprises have been positive, but from a low bar
The recent pro-cyclical tilt of the equity rally might in part be due to expectations of more reflationary central bank polices, but it has also been supported by a better macro backdrop relative to expectations. Our global macro surprise index (MAP) had an increase in July, driven by developed markets (Exhibit 14). And the correlation of equities with macro surprises has been positive, i.e. it’s a ‘good news is good news’ environment as dovish Fed expectations have been anchored. However, the positive macro surprises might in part be due to lowered expectations into and after Brexit. Friday’s US GDP release came in below expectations, primarily owing to a sizeable inventory correction.
... and the market's take on monetary policy, which is at odds with an economy that is supposedly improving:
The current dovish Fed pricing is at odds with current macro trends, the significant easing of financial conditions during the relief rally and our economists’ forecast of above 2% US GDP growth in 2H2016. The repricing of Fed hikes since the beginning of the year has been extreme and now little is priced until 2018 (Exhibit 16). Our economists see a 65% probability of a hike this year (45% for December and 20% for September) post the Fed’s recent meeting as the FOMC indicated nearterm risks to the economic outlook have diminished, although Friday’s US GDP came in below expectations. Bearish rate shocks have put upward pressure onglobal bond yields, which could continue.
In short, Goldman believes the key risk to sentiment, and pricing, is that monetary policy expectations will disappoint.
So far, both the BoE and ECB have been on hold. Our economists expect the BoE to announce a 25 bp cut in the bank rate, Gilts and corporate bond purchases and an extension of the Funding for Lending Scheme. And they expect the ECB to extend its asset purchase programme to the end of 2017 (currently March 2017) at the September meeting, and the key according to which purchases under the PSPP are taking place to be changed from the ECB’s capital key to market capitalisation of debt outstanding. New fiscal easing in Japan is also broadly expected in the near term (see Japan Views: Economic stimulus package upwards of ¥28 tn, but real water component likely only around ¥5 tn over several years, July 27, 2016), but we have concerns that this fails to sustainably boost the market, as has often been the case in the past (see Japan Strategy Views: History Lessons, July 26, 2016). Unless expectations can be met or exceeded, the chances of another drawdown are heightened, in our view.
Taking all this into considerations, Goldman's latest conclusion is relative simple: sell.
Policy uncertainty is still high post Brexit and has increased further in Europe, the US and China, in our view. In Europe, the Brexit negotiations are likely to take time; in the US, the general election cycle is starting; and in China, concerns have picked up – in fact, our economists have highlighted again a significant pick-up in FX outflows in June amid RMB weakening. Geopolitical risks have also moved again into focus with further terror attacks globally and the attempted military coup in Turkey on July 15, 2016. With equities at the high end of their range, we think shocks such as these can drive downside from here.
Will Goldman again be wrong? It's distinctly possible, in which case we expect the firm to capitulate some time in September, when the S&P is around 2,300 and urging what clients it has left to buy stocks at all time highs. That would clearly market the moment to sell everything. On the other hand, considering Goldman dreadful forecasting record over the past year, it is about time the firm got one reco right, if only purely statistically. But just to be safe, it may be wisest to wait until Gartman turns "pleasasntly long."