With Q3 earnings season looking unexpectedly strong after the first 2 weeks of reporting, which granted have focused on the otherwise strong banks and tech companies with energy and retail still to come, with some 80% of companies beating expectations and hope returning that this may be the quarter when the 1+ year long earnings recession find ends, moments ago Goldman's David Kostin poured cold water over the S&P's earning prospects when earlier this morning the strategist announced that he is "trimming our S&P 500 earnings forecasts" for the next three years.
- We cut our S&P 500 earnings estimates for each of the next several years. Our revised operating EPS forecasts now equal $105 (2016), $116 (2017), and $122 (2018) reflecting annual growth of 5%, 10%, and 5%, respectively. Low interest rates and peaking margins constrain profit growth in Information Technology, Financials, and Telecom and drive the reduction in our index-level EPS forecast.
- Our earnings model projects 5% sales growth and 8.5% margins for the S&P 500 in 2017 with margins peaking next year and starting to decline in 2018.
- We maintain our S&P 500 price targets of 2100 for year-end 2016, 2200 at the end of 2017, and 2300 at the end of 2018, implying price changes from the current market level of -3%, +2%, and +6%, respectively.
- From a valuation perspective our unchanged year-end 2016 target of 2100 represents a forward P/E multiple of 18x our 2017 top-down operating EPS estimate of $116 and 17x our 2017 top-down adjusted EPS estimate of $123, ranking at the 85th percentile relative to the past 40 years.
- Key issues for investors in 2017: (1) secular stagnation and (2) peaking margins.
Summary of Goldman Sachs US Portfolio Strategy forecasts, 2015-2019E
Some more details explaining the reasoning behind Goldman's trimming of future growth prospects, driven primarily by reduced expected growth, peaking margins and the risk of secular stagnation.
We lower our 2016 and 2017 S&P 500 operating EPS estimates by $5 and $7, respectively. Our reduced 2016 forecast of $105 (from $110) reflects annual growth of 5%. For 2017, we expect operating EPS will rise by 10% to $116 (down from $123). Looking further into the future we expect earnings will rise by 5% to $122 (from $130) in 2018 and by 4% to $127 in 2019 (see Exhibit 1).
Lower expected growth in three sectors explain the majority of our forecast reductions. Financials and Information Technology, the two largest S&P 500 sectors based on EPS contribution, have both registered disappointing operating EPS growth in 2016 YTD. We now expect Financials EPS will rise by just 1% in 2016, down from our previous forecast of 9% growth. Low long-term interest rates have crimped Financials earnings and comprise $2 of the aggregate $5 reduction in our overall S&P 500 EPS forecast. We also slashed our Information Technology and Telecom Services 2016 EPS estimates by roughly $2 each. Information Technology EPS will fall by 4% in 2016 as net margins decline by 170 bp. We expect Telecom operating EPS will decline in 2016 as low interest rates increase pension liabilities. Information Technology and Financials are also the major contributors to the reduction in our 2017 S&P 500 EPS forecast.
Following the recent recovery in oil prices, we now expect Energy sector losses will subtract only $1 from S&P 500 EPS in 2016, compared with the -$3 contribution that we had previously forecast. A rebound in crude oil prices mean that Energy write-downs, which have plagued S&P 500 EPS for more than a year, should fade in the second half of 2016. Earnings for the Energy sector will be less negative this year than in 2015 (which was the first time in 48 years the sector posted an operating loss). In fact, overall S&P 500 operating EPS growth of 5% in 2016 is almost entirely attributable to Energy. We forecast just 1% EPS growth outside of Energy this year.
For 2017, we expect modest EPS growth in most sectors will lift overall S&P 500 operating EPS by 10% to $116. Financials EPS (+6%) should benefit from higher rates at both the short-end and long-end of the yield curve. The futures market currently implies one hike in fed funds during 2017 and an average 10-year Treasury yield of 1.9%. Goldman Sachs economists forecast the 10-year Treasury yield will end 2017 at 2.5%. We expect Information Technology earnings will grow by 8% in 2017, the strongest rate of any sector. Information Technology earnings will benefit from market-leading sales growth of 7% coupled with a slim 10 bp rise in profit margins.
For 2018 and 2019 we forecast annual sales growth of 5% and a 10 bp annual decline in net margins will result in S&P 500 operating EPS growth of 5% and 4% to $122 and $127, respectively.
Exhibit 1: Goldman Sachs top-down and consensus bottom-up S&P 500 EPS forecasts, 2016E-2018E
Exhibit 2: S&P 500 annual year-over-year EPS growth, 1972-2019E
Exhibit 4: Sensitivity of Goldman Sachs 2017E S&P 500 operating EPS to macro variables
Looking at next year, Goldman focuses on two key earnings issues for the S&P 500 in 2017, namely the admission that the "above trend" growth thesis preached by Jan Hatzius over and over over the past three years is now over:
Steady but unspectacular profit growth will be a hallmark of 2017 earnings. While we forecast that S&P 500 operating EPS will rise by a strong 10% next year, outside of the Energy sector, earnings will grow at a modest 6% pace, below the average annual S&P 500 EPS growth rate of 7.5% since 1980. Looking under the surface, we expect two issues will drive the earnings discussion next year:
1. The US economy will remain stuck in a slow secular growth regime
Our economists forecast that real GDP growth in the US will persist at a roughly 2% annual pace through 2019. Our earnings model assumes real GDP growth averages 2.1% in 2017 but the estimated trend growth rate has been trimmed to just 1.75%. Increased infrastructure spending represents a source of potential upside to our estimate. However, the benefit from increased government spending is unlikely to kick in until 2018, when new budget deals would go into effect. We estimate that every 100 bp change in 2017 US GDP growth relative to our baseline assumption equates to a $5 change in 2017 S&P 500 EPS, or 5 percentage points (pp) of EPS growth.
2. S&P 500 margins will increase slightly next year, but remain well below the peak
We expect S&P 500 margins, excluding Financials, Real Estate, and Utilities, will rebound by 53 bp to 8.5% in 2017. A continued recovery in Energy fundamentals will lift sector margins from -0.6% to +3.7% and will push overall S&P 500 margins up in 2017, but margins will remain considerably below the peak of 9.2% in 3Q 2014. Information Technology margins will be in the spotlight after a significant compression in 2016. We forecast that Information Technology margins will fall by nearly 170 bp in 2016 and then rise by 10 bp next year. At the S&P 500 index-level, every 50 bp change in margin impacts EPS by $5 per share. Macro headwinds that will affect margins in different sectors include pricing power, capacity utilization, and labor costs.
Not helping the upside case is Goldman's expectations that S&P 500 margins will remain well-below the peak, something which others may be tempted to call "stagnation" especially if inflation were to finally break out.
S&P 500 margins have declined by nearly 150 bp since peaking at 9.2% in 3Q 2014. The precipitous decline in Energy sector margins, largely as a result of asset write-downs, accounts for the majority of the fall in S&P 500 margins. However, declines outside of Energy have weighed on S&P 500 margins during the first half of 2016, particularly in the Information Technology sector. Trailing four-quarter margins for the S&P 500 ex-Energy have declined by 25 bp since December.
We forecast S&P 500 operating margins will expand by 10 bp to 8.0% in 2016 before rising to 8.5% in 2017. A rebound in Energy margins will fuel most of the overall margin expansion during the next two years. S&P 500 margins ex-Energy have already peaked. We expect margins outside of the Energy sector will fall by 50 bp to 8.8% in 2016 before rising to 9.0% during 2017. Consensus bottom-up forecasts imply that adjusted margins will decline by 34 bp in 2016, before increasing by 42 bp in 2017.
Exhibit 9: S&P 500 net margin will reach 8.5% in 2017 but fall to 8.4% in 2018
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So what does all this mean for Goldman's S&P500 price targets? Apparently, not much as Hatzius expected multiples to expand sufficiently to compensate for the dip in earnings:
Despite trimming our S&P 500 EPS projections, we continue to forecast the S&P 500 index will trade at 2100 by year-end 2016. The trajectory of the S&P 500 index will track in-line with adjusted earnings growth, rising to 2200 (+5%) in 2017 and 2300 (+5%) in 2018.
Both Goldman Sachs Economics and the futures market expect the Fed will hike rates by 25 bp in December 2016. For 2017, our economists expect 75 bp of rate increases starting in June while the futures market implies 25 bp of hikes next year. Rising interest rates and tighter financial conditions suggest further valuation expansion is unlikely.
We expect the forward P/E multiple will remain at roughly 17x adjusted EPS through 2018 (see Exhibit 32). Our forecast for S&P 500 adjusted earnings suggests growth of 5% in both 2017 and 2018 followed by 4% in 2019, representing adjusted EPS levels of $123, $129, and $134, respectively. Our 2016 target of 2100 represents a forward P/E multiple of 18x our 2017 top-down operating EPS estimate of $116 and 17x our 2017 top-down adjusted EPS estimate of $123, ranking at the 85th percentile relative to the past 40 years. Forward P/E will remain steady at 17x adjusted EPS as S&P 500 rises alongside modest EPS growth, increasing from 2100 at the end of 2016 to 2200 (+5%) by the end of 2017 and to 2300 (+5%) by year-end 2018.
Exhibit 31: S&P 500 operating EPS forecasts and index targets, 1996-2018E
Exhibit 32: S&P 500 aggregate and median forward P/E ratio: We expect forward P/E of 17x