Goldman Sachs really wants the market lower.
After several increasingly more comprehensive critiques of Trump's fiscal policies (most recently this past weekend), on Friday, just as the S&P closed at fresh all time highs propelled by a late day ramp, Goldman's chief equity strategist who has a 2,300 year end target on the index, cautioned that "cognitive dissonance exists in the US stock market" as "investors must reconcile S&P 500’s performance with negative EPS revisions from sell-side analysts." Specifically, Kostin notes that the "S&P 500 has returned 10% since Election Day while consensus 2017E adjusted earnings have been lowered by 1%", and predicts that "investors will soon de-rate their expectations of potential 2017 EPS growth as they face the reality that the accretive impact from tax reform will not occur until 2018."
In short, "Financial market reconciliation lies ahead: We are approaching the point of maximum optimism and S&P 500 will give back recent gains as investors embrace the reality that tax reform is likely to provide a smaller, later tailwind to corporate earnings than originally expected."
First, Goldman points out that the underlying current of optimism unleashed with the Trump election is no longer warranted:
Cognitive dissonance exists in the US stock market. S&P 500 is up 10% since the election despite negative EPS revisions from sell-side analysts (see Exhibit 1). Investors, S&P 500 management teams, and sell-side analysts do not agree on the most likely path forward. On the one hand, investors, corporate managers, and macroeconomic survey data suggest an increase in optimism about future economic growth. In contrast, sell-side analysts have cut consensus 2017E adjusted EPS forecasts by 1% since the election and “hard” macroeconomic data show only modest improvement.
Some of the optimism has to do with a jump in Q4 earnings, however much of that has to do with a slowdown in energy company writedowns.
On an operating basis, EPS grew by 24% aided by a recovery in Energy profits. Energy operating EPS recovered from -$2.43 in 4Q 2015 – the lowest level on record since 1967 – to $0.29 in 4Q 2016 as asset write-downs slowed. Energy contributed 13 pp of 24 pp to 4Q S&P 500 EPS growth. Index-level operating EPS grew by roughly 6% in 2016; we expect 10% growth in 2017.
While there has certainly been an earnings rebound, the future is far less exciting than the recent rally will make it appear.
Investors are optimistic about an improvement in economic growth and the prospect of increased corporate EPS. All 11 sectors contributed to the 10% rise in the S&P 500 index, with Financials and Information Technology contributing 30% and 22% of the 208 point gain. Decomposing the strong performance shows reduced EPS growth has been more than offset by P/E expansion which accounts for all the index gain (Exhibit 2).
Goldman then notes that while corporate management team commentary from Q4 earnings calls substantiates some of this optimism, forward EPS do not justify it, and indeed "analyst EPS estimates paint a different picture. Consensus 2017E adjusted EPS has been revised downward by 1% over the last 3 months. Sell-side analysts appear hesitant to incorporate potential tax reform and deregulation into their estimates given elevated policy uncertainty. Positive revisions to aggregate S&P 500 EPS estimates are rare – during the last 33 years, consensus EPS estimates have been revised upward from their starting point just six times."
Kostin then points out something we have shown on various occasions in the past month: the recent "recovery" has been all in soft economic indicators such as sentiment and outlook. Hard data has for the most part, faded the entire bounce since the election:
“Hard” macroeconomic data has shown only modest improvement. Housing indicators have flashed mixed signals with a notable decline in the latest reading of new home sales. Industrial Production was weaker-than-expected in January (-0.3% vs. median forecast of flat) and the December reading was revised down.
Just as Congressional Republicans are likely to use the reconciliation process to pass fiscal policy legislation this year, so must investors reconcile S&P 500 performance with corporate earnings. We are approaching the point of maximum optimism regarding policy initiatives. Our US Economics team expects a tax reform package may not pass until late 2017 or early 2018. Even so, the tailwind to corporate earnings from tax reform will be constrained by the unwillingness of certain Congressional Republicans to significantly expand the federal budget deficit.
Kostin's conclusion: "We expect investors will soon de-rate their expectations of potential 2017 EPS growth as they face the reality that the accretive impact from tax reform will not occur until 2018. Many investors have incorporated lower taxes in a 2017 S&P 500 earnings estimate of roughly $130, reflecting 11% growth. In contrast, our S&P 500 adjusted EPS estimate for this year remains $123, just 5% above the flat earnings of 2014, 2015, and 2016. We forecast S&P 500 will peak in 1Q at 2400 before slipping to 2300 by year-end."
It's perhaps worth noting once again, that every time Goldman has warned that a market turnaround is imminent, the S&P has proceeded to surge to new highs. For those expecting Trump's first market correction, or worse, they may have to hold their breath until the bank that spawned most of Trump's economic advisors finally throws in the towel and says to buy at any price.