Just days after Barclays released its 2018 equity outlook with the title "Rational Exuberance"...
... Goldman's David Kostin decided that imitation is the sincerest form of flattery and in presenting his S&P price target* for 2018 (and 2019 and 2020), and has named his preview report the same:
We footnoted price target, because once again Kostin has decided to avoid making a definitive forecast for where the S&P will go in the near term, and instead - as he did one month ago - has left the trajectory of the S&P entirely contingent on the fate of tax reform over the next few months.
That said, and not surprisingly, Goldman is optimistic and sees the bull market continuing for at least another three years due to an "extended profit cycle will support a rising US equity market through 2020." As a result, Goldman sees higher profits supporting higher index levels, and its S&P 500 year-end forecasts are 2850 (2018), 3000 (2019), and 3100 (2020) for gains of 11%, 5%, and 3%."
Going back to the caveat, however, Kostin writes that "assuming tax reform passes, we forecast 2018 S&P 500 EPS will jump by 14% to $150 and the index will advance by 11% to 2850 at year-end 2018. If tax reform fails, S&P 500 will fall near-term by 5% to 2450."
Assuming tax reform does pass, and the market does not undergo the predicted 5% hiccup, Goldman's prediction is based on, you guessed it, "rational exuberance", to wit:
- The bull market will continue in 2018: Our “rational exuberance” rests on a combination of above-trend US and global economic growth, low albeit slowly rising interest rates, and profit growth aided by corporate tax reform likely to be adopted by early next year. Assuming tax reform passes, we forecast S&P 500 adjusted EPS will jump by 14% to $150 in 2018. Equity investors will be rewarded as the index advances by 11% to 2850 at year-end 2018 and delivers a total return of 13% including the 2% dividend yield
- Tax reform and strong economic growth drive our improved profit outlook. We raise our S&P 500 EPS estimates to $150 (2018) and $158 (2019) reflecting growth of 14% and 5%. Our forecast assumes tax reform and is above bottom-up consensus for 2018 ($146) but below for 2019 ($161) given we forecast flat (10.5%) rather than rising (10.8%) margins.
- One final year of valuation expansion before multiples plateau. Our target implies a 3% P/E expansion to 18.2x at year-end 2018. Our valuation framework incorporates: (1) relationship between ROE and Price/Book ratio; (2) Fed Model earnings yield gap reverts to its 40-year average while Treasury yield rises to 3.0% during the next 12 months; (3) rising short- and long-term interest rates.
As noted above, Goldman raises its S&P 500 adjusted EPS estimates to $131 in 2017 (from $129) and $150 in 2018 (from $139) reflecting growth of 14%. In addition to a stronger economic backdrop for corporate earnings, Goldman's baseline EPS estimates now include a 5% boost from corporate tax reform in 2018.
In summary, there are four drivers to Goldman's increased earnings forecast: (1) tax reform, (2) strong 2017 earnings results, (3) higher US GDP growth, and (4) higher oil prices. Excluding tax reform, we expect less margin expansion and slower EPS growth than consensus in 2018 and 2019. Our EPS estimates without tax reform are $143 (2018), $151 (2019), and $156 (2020).
What is also notable, is that Goldman anticipates tax reform - if it passes - boosting profit margins only one year: from 2018 to 2019, with the rest staying flat. Also notable: Goldman sees all profit margin growth being derived on the back of tech companies, as shown in the chart below. Ex-Info Tech margins are flat at best:
We forecast S&P 500 margins will peak in 2018 at 10.5%. Aided by the secular rise in Information Technology margins, current trailing 4-quarter S&P 500 net profit margins stand at 9.8%, a record high, and we expect full-year 2017 margins will equal 9.9%. A one-time boost from a reduced corporate tax rate and strong revenue growth for large-cap technology companies will lift 2018 margins by 56 bp to 10.5%. We expect margins will decline modestly through 2020 as late-cycle pressures continue to mount.
That said, exuberance, whether rational or otherwise, is clearly present, as Goldman makes clear:
After a nine-year rally, stocks now trade at lofty valuations relative to history on both an absolute and relative basis. S&P 500 has returned more than 350% (a 19% annualized total return) since the index bottomed in March 2009. Both the aggregate S&P 500 index and the median stock trade at extremely elevated P/E, P/B, EV/Sales, and EV/EBITDA multiples. Similarly, government bond yields on both a nominal and real basis are low (implying high valuation) and credit spreads for both investment-grade and high yield bonds are tight by historical standards.
Furthermore, any mentions of exuberance will immediately bring up the 1990s bull market, when the term first emerged courtesy of one Alan Greenspan:
On December 5, 1996, with the S&P 500 index trading at a then record high forward P/E multiple of 15x, Federal Reserve Chairman Alan Greenspan delivered a speech to the American Enterprise Institute in which he noted: “Clearly sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by P/E ratios and the rate of inflation in the past.” (The Age of Turbulence: Adventures in a New World, Alan Greenspan, Penguin, 2007, page 177).
Chairman Greenspan went on to pose a famous rhetorical question in the next sentence of his speech: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?” At the time, the Fed chair was concerned about what he perceived as the “looniness” of stock prices. He “worried that investors were getting carried away and stock prices were beginning to embody expectations so exorbitant that they could never be met” (p. 174).
Perhaps a more apt phrase would be one made legendary by Citi's then CEO Chuck Prince who said that "as long as the music is playing, you've got to get up and dance." One look at market and it is abundantly clear that there is a lot of dancing going on. And since nobody wants to be the first to spoil the part, Goldman will get on board, however grudgingly, as the following caveat reveals:
Unfortunately, it is only in retrospect that one can definitively establish that assets have reached unsustainable levels. Greenspan was prescient, but three years early. Following Greenspan’s speech warning of the potential for excessive valuations, the S&P 500 subsequently more than doubled (+116%) during the next three years before the Tech bubble finally peaked in March 2000 at a forward P/E multiple of 24x.
So assuming assets haven't yet reached unsustainable levels, what can one say, besides what Barclays already said last week: the rally is exuberant... but rational!? Here's Goldman:
“Rational exuberance” best describes our forecast for the trajectory of the S&P 500 during the next several years. Earnings drive stocks over time and should support the index rising to 2850 at year-end 2018, 3000 at the end of 2019, and 3100 by the close of 2020, representing a price gain during the next three years of 20% (see Exhibit 1). Our price targets imply a modest expansion in forward P/E multiple to 18.2x at year-end 2018, a flat multiple in 2019, and a contraction to 18.1x in 2020.
An earnings-driven bull market is inherently rational for a fundamental equity investor. Decomposing the building blocks of a rally allows an investor to differentiate between what has a foundation of stone and what is a castle in the air. Between 1987 and 1996, the S&P 500 index was lifted by roughly 30% from P/E multiple expansion and 70% from earnings growth. The components of the current bull market that started in 2009 are similar: Valuation expansion has accounted for about 30% of the rally, profit growth about 50%, and the remaining 20% from an increase in expected EPS growth.
Meanwhile, this is what Goldman would defined as irrational exuberance:
We would deem it “irrational exuberance” if the S&P 500 during the next three years followed the exponential trajectory of stocks in the late 1990s. In that situation, the S&P 500 would trade at 5300 by year-end 2020 (a 105% rise from today). If stocks instead trade at a similar forward P/E to the Tech Bubble (24x), it would imply a year-end 2020 index level of 4050 (57% above today). During the three years post Greenspan’s speech, S&P 500 EPS rose by 26% ($40 to $50). Translated to today, such a growth rate would imply 2020 EPS of $166 compared with our estimate of $163.
To be sure, despite conceding that valuations have never been higher, Kostin tries to make an attractive valuation argument for the S&P, to which he counters that one could still see modest multiple expansion, although most of this is now in the past. As a result, the big wild card is whether tax reform passes or not, needless a rather major gamble when the delta is 400 S&P points:
Today, the S&P 500 effectively trades at a forward P/E multiple of 17.7x. The index currently trades at 18.1x forward bottom-up consensus EPS of $143. However, if the market were fully assuming corporate tax reform, then the forward EPS estimate would be $150 (assuming our estimated $7 boost from tax reform) and the index would be trading at a forward P/E multiple of 17.3x. Based on the relative performance of tax-exposed equities and prediction markets, we estimate the market assigns a roughly 50% likelihood that corporate tax reform is adopted. Using a blended EPS estimate of $146 implies the market effectively trades at a forward P/E multiple of 17.7x.
Once again, Goldman's entire 3 year forecast is contingent on just one thing: tax reform.
The largest contributor to our increased EPS estimates is corporate tax reform. Two weeks ago, the House and Senate released their respective tax reform proposals. Considerable uncertainty surrounds the final provisions of the plans, but both chambers have incorporated a tax cut of roughly $1.5 trillion over the next 10 years. Our political economist assigns an 80% likelihood that tax legislation will pass by 1Q 2018. Our baseline forecast includes several key tenets: (1) a reduction in the domestic federal statutory corporate tax rate; (2) a territorial system for foreign income, including a minimum tax rate; (3) a limit on interest deductibility; (4) immediate business equipment expensing; (5) base broadening; and (6) a one-time tax on overseas cash and earnings.
Tax reform aside, bizarrely, Goldman's argument boils down to whether the exuberance that drives the market for the next 3 years is rational or irrational. It looks something like this:
There are caveats, chief among which is that the rally will in just two weeks become the 3rd longest in history with a 5% dradown, and just 24 days later, the longest on record.
Low volatility is perhaps the most remarkable aspect of the current bull market. It has been more than 350 trading days since the S&P 500 has experienced a drawdown of 5% or more, the fourth-longest period since 1930 (see Exhibit 3). Realized volatility stands at the lowest level in 50 years. Moreover, the market term structure implies volatility will remain well-below average during the next five years. In his memoir, Greenspan notes that “one major factor causing stock prices to rise [in the 1990s] was investors’ growing confidence that stability would continue.” (page 175).
of course, there are also risks that Goldman's entire forecast will be dead wrong, and we will cover these shortly in a follow up article.