Ten days ago, Goldman's Peter Oppenheimer published the "Long Good Buy, The Case For Equities", a big research piece, full of pretty charts and witty bullets, which actively urged the rotation out of bonds and into stocks, yet not only marked the peak of the market so far, but drew ridicule even from the likes of CNBC. More importantly, it has generated a plethora of questions from the muppets (aka Goldman clients) themselves, who are wondering how Goldman can be both uber bullish, and yet still have a 1250 S&P 2012 YE price target, as per the other strategist, David Kostin ("We expect the S&P 500 will trade at 1325 by mid-year (-5.6%) and 1250 in 12 months (-10.9%)."), or said otherwise, just how is it that Goldman is having its cake and eating it too? Below is David Kostin's attempt to justify how the firm can pull a Dennis Gartman (and virtually any other newsletter and book seller - after all what better way to say one was right than to have all bases covered) be both bearish and bullish at the same time.
From Goldman's US Weekly Kickstart
Last week, Peter Oppenheimer and our European Portfolio Strategy team published "The Long Good Buy; the Case for Equities" in which they conclude equities are attractive for three reasons: (1) Periods of poor real returns in equities tend to be followed by periods of significantly higher returns; (2) equity valuation appears low versus bonds; and (3) an elevated equity risk premium (ERP) supports a long-term positive view for stocks.
We agree with the long-term thesis. Investors willing to position for a normalized growth and risk environment over the next decade should interpret high ERP and low implied growth as an investment opportunity.
However, path matters and our price targets reflect short-term tactical risks. We believe equity valuation will remain below average over the next year due to stagnant economic growth and high uncertainty. Both views can comfortably co-exist in the context of different investment horizons.
S&P 500 currently trades above fair value on a variety of metrics although the index is attractively valued relative to bond yields given the low interest rate environment. Equity investors fall into many categories and we believe views are currently most differentiated between equity-focused vs. cross-asset investors and short- vs. long-term investment horizons. Investors that actively invest in multiple asset classes and/or can look past near-term risks are generally more positive on US equities.
Last week we published three US Equity Views reports on valuation of equities vs. bonds, dividends, and S&P 500 today vs. 2007 peak. We address below questions clients raised most frequently:
Q: How do global markets currently trade relative to their previous peaks?
A: S&P 500 trades 10% below its 2007 peak, Asia-Pacific ex-Japan is 26% below, Europe is 35% below and Japan is 53% below. TOPIX is 70% below its 1989 level. The level of earnings has recovered and stands at new highs in both US and Asia-Pacific ex-Japan. However, earnings are well below 2007 peaks in Europe (15%) and Japan (50%).
In contrast, the expected earnings growth rates increased in Japan (13% to 50%) and are unchanged in Europe at 8%. Forward EPS growth rates have declined in US (13% to 9%) and Asia-Pacific ex-Japan (17% to 13%). Every region has de-rated and remains below 2007 peak levels. Asia Pacific ex-Japan has experienced the largest P/E de-rating despite having the largest forward EPS growth. Earnings grew by 18% but the forward multiple fell by 34% to 11.4x from 17.3x. MXAPJ is 26% below its 2007 peak.
In Europe, the Stoxx 600 is 35% below its 2007 peak. Performance can be attributed to both multiple contraction and lower earnings given the expected forward earnings growth has remained unchanged.
In Japan, TOPIX sits 53% below the 2007 high. The collapse in earnings, which are 50% below the 2007 “peak,” and multiple contraction of 28% are negative impacts to the Japan market level. Relative to the 1989 peak, earnings are flat, but the multiple has compressed by 73%.
Q: Do buybacks and issuance affect 2007 and 2012 EPS comparisons?
A: S&P 500 EPS is the sum of all constituent earnings divided by the index divisor. Company-level earnings are calculated as the EPS of the firm multiplied by the company’s float-adjusted share count. The earnings contribution of a firm earning $2 per share with 50 shares is the same as a company earning $1 per share with 100 shares. The divisor is also adjusted on share changes, and this can affect index-level EPS. We can remove this by calculating earnings growth rather than EPS growth. S&P 500 LTM earnings are 9% above the 2007 level while EPS grew 6%.
Q: Earnings and margins recovered. Where are sales relative to peak?
A: S&P 500 trailing four quarter EPS and margins peaked in 2Q 2007 but sales, both including and excluding Financials and Utilities, peaked 15 months later in 3Q 2008. Full-year 2011 sales excluding Financials and Utilities are 16% above 2Q 2007 levels but 1% below 2008 peak levels.
Q: Isn’t EPS growth just the result of higher margins from cost cutting?
A: Comparison of full-year 2011 earnings, sales, and margins versus 2007 peak suggests higher sales, not margin expansion, drove the majority of EPS growth. This is because sales and earnings (excluding Financials and Utilities) peaked together in 3Q 2008. Full-year 2011 sales remain just below 2008 levels, but earnings reached new highs, driven by margin expansion.
Q: Despite the valuation-driven rally, the S&P 500 trades below the 10-year average P/E. How is the market valued using other metrics?
A: With a forward P/E of 13.2x, S&P 500 trades one standard deviation below its 10-year average. S&P 500 trades between 0.5 and 1 standard deviations attractive using most valuation metrics we track (see Exhibit 4). Historical average valuation would imply a rise in S&P 500 of about 14% to 1600.
However, we don’t view mean reversion as appropriate given margins have started to fall from record levels and US GDP is growing below trend.
And now you know why one can be both bullish and bearish, while soaking up million in soft-dollars.