"How Much Worse Will It Get?" That's What Goldman's Clients Want To Know

Last weekend, just after the 666-point crash in the Dow which seemingly came out of nowhere after the market misinterpreted the average hourly wages print as strong (when in reality it was weaker than expected when factoring in the slide in hours worked), Goldman's clients had just one question: with the market suddenly tumbling after the best start to the year since 1987 (other parallels included a collapse in the dollar and a spike in yields), was this 1987 all over again?

Goldman's response, as delivered by the bank's chief equity strategist David Kostin, predictably was 'don't panic, things are very different than they were 31 years ago.'

In retrospect, and considering the immediate market plunge that followed, what happened next certainly certainly had the feel of 1987, Goldman's clients should have been asking Bank of America , which on payrolls Friday correctly predicted that a 12% plunge was imminent.

Meanwhile Goldman's David Kostin was out there defending his bullish thesis (even if he quietly suggested that "investors who are already long cash equities could instead consider purchasing puts as protection".)

Well, it's one week later, the biggest ever point crash in the Dow Jones is in the history books, as is the volocaust which sent the VIX up by the most on record and imploded the inverse VIX industry.

So yes, to all those clients who are wondering how the smartest FDIC-backed hedge fund investment bank could get it so wrong, we suggest you read "Goldman Does It Again: Crude Crashes 11% After "Most Bullish In A Decade" Call."

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Fast forward one week later when the same David Kostin, whose infectious enthusiasm last Friday just cost his clients millions, tells us that the biggest question worrying Goldman (suddenly poorer) clients is no longer "is it really bad" - it is - but "how much worse will it get?"

It will probably not shock readers, to learn that once again Kostin - like JPM's Marko Kolanovic two weeks ago - has just one job: to prevent a liquidation panic, and to restore confidence that the 10% correction which just happened seemingly out of nowhere was a one off event, or - in the parlance of Wall Street - a "healthy correction."

Alas, after last week's forecast disaster, Kostin's promises that all is well have about as much value as an $100 XIV call. So instead of piling on his discredited opinion, here are the facts from the chief Goldman strategist, the bottom line being that once there is a correction, the market will likely keep selling for a while, with the peak to trough change for non-recession corrections 15%, and 27% for corrections that morph into outright recession, and a blended average drop of 18%, or roughly double the current drawdown.

Here are the details:

Most equity market corrections recover without developing into bear markets or presaging recessions. There have been 16 drawdowns of 10%+ since 1976. Of the 16 corrections, only five occurred around a recession. Of the remaining 11 non-recession episodes, 1987 was the only one that turned into a bear market (i.e., a decline of 20%). A bear market would mean the S&P 500 falls below 2300, which history suggests is unlikely to occur without a recession. Our economists believe the probability of a recession remains well below average, given strong global GDP growth and loose financial conditions. Earnings fundamentals also remain strong. Since the market peak, consensus 2018 EPS have been raised by 2%. Consensus EPS expectations rose by a median of 1% during corrections not associated with recessions compared with a decline of 3% in recession corrections.

In other words, the S&P 500 typically declined by 15% during the 11 non-recession corrections since 1976. Putting this in current context, a fall of this magnitude would carry the index to 2450, roughly 6% below the current level.

Some other facts: The typical correction took 70 trading days to trough and 88 days to recover. However, an investor who bought the S&P 500 10% below its peak without waiting for a bottom would have experienced median 3-, 6-, and 12-month returns of 6%, 12%, and 18%.

For those looking for a more granular breakdown, Kostin notes that market performance following past non-recession corrections suggests investors should prefer cyclical sectors to defensives (see Exhibit 3).

  • Materials has beat the S&P 500 by a median of 270 bp during the three months following past corrections. Industrials outpaced the index in 73% of periods by a median of 270 bp.
  • Telecom has been the worst post-correction performer, lagging the index in 64% of periods by a median of 410 bp.
  • Among factors, low valuation and small-cap stocks typically performed best following 10% declines. The Russell 2000 index has outpaced the S&P 500 by a median of 240 bp.
  • Low volatility stocks typically fare worst, lagging high volatility firms in 87% of post-correction periods by a median of 610 bp.

Finally, for those who simply hope to fade any advice Goldman brings to the table, just do the opposite of this:

We recommend investors focus on Cyclicals and Low Labor Cost stocks now that the long-awaited correction has occurred. Exhibit 4 identifies 25 Goldman Sachs Buy-rated stocks that have lagged most during the current correction relative to their respective beta-implied returns. The median stock has a beta of 1, but has lagged its beta-implied return by 5 pp since January 26.

For readers who believe the correction is only just starting, the choice is clear: just short Goldman's top 25 "laggard" stocks.

NYSE, October 19, 1987.