After the inflation in P/E multiples has sent the S&P500 to to a level above the 90% percentile of all historical valuations, Goldman has called a time out, and says that there will be no more multiple expansion. As a result only one thing will push stock prices higher “as equity valuations compress as interest rates rise” – higher profits.
In his latest note, Goldman’s equity strategist David Kostin says that his tactical view remains that S&P 500 has peaked at 2400 and (unlike BofA’s recent flipflop which now expects the S&P to keep rising to 2,450 after earlier predicting a 2,300 year end target) will fade to 2300 by year-end. In fact, looking dead ahead, Goldman comes about as close as it has in recent months warning of an imminent market drop: “investors will soon capitulate on their expectation of upside to 2017 EPS forecasts as they face the reality that the accretive impact from tax reform will not occur until 2018. In fact, revisions to consensus EPS forecasts during the past few months have been negative for both 2017 and 2018.”
But don’t worry: like other recent sellside notes, any imminent corrections (or crashes) will be a “buy the dip” opportunity, and thus Goldman keeps its year-end 2019 S&P 500 target at 2500, a 6% rise from the current index level and implies a forward P/E multiple contraction of 5% to 18x.
Below are some further observations on the current state of the market from Kostin.
Thursday marked the 8th anniversary of the current bull market, making it the second-longest on record. On March 9, 2009, the S&P 500 index traded at 677 and it now stands at 2365, reflecting a price gain of 250% or 17% annualized (19% annualized with dividends). Happy Birthday indeed!
But the current bull market is really a tale of two sub-cycles (Exhibit 1).
During the first phase (March 2009 to April 2011), the market rallied on the back of a rebound in earnings from the depths of the Global Financial Crisis. Higher profits accounted for 66% of the index’s 102% gain while P/E multiple expansion explained just 17% of the rally (faster expected EPS growth contributed the remainder; see Exhibit 2).
In 2011, the US only narrowly averted defaulting on the national debt. As Congress dithered over the debt ceiling, the S&P 500 plunged by 19%, just missing the 20% threshold typically used to define a bear market. Hence, some investors debate over whether the current bull market started from the low in 2009 or after the debt ceiling debacle in 2011. Since the market low of 1099 in 2011, the S&P 500 has climbed by 115%.
This second phase of the bull market has lasted more than five years and has been driven mostly by an increase in valuation rather than the level of profits. The adjusted P/E multiple climbed to 18x from 10x, explaining 71% of the rise in the index. Higher earnings accounted for just 28% of the rise.
After the inflation in P/E multiple, the S&P 500 now trades at the 90th percentile of historical valuation relative to the past 40 years. Current consensus forward P/E of 18.1x is the highest level since 1976 outside of the Tech bubble. The median stock trades at the 99th percentile vs. history.
The drivers of a bull market matter for investors. Some rallies are powered by earnings while others rely on valuation. Since 2011, real GDP expanded at an average annual pace of 2%, Fed funds hovered at extraordinarily low levels, and the valuation of stocks surged. However, looking forward, growth in an economy with limited slack will lead to rising inflation, higher interest rates, and a lower P/E multiple.
We are on the cusp of the Fed accelerating its pace of tightening. The Current Activity Indicator (CAI) from our US Economics team stands at 4.4% following the strongest ADP report in three years, above-consensus payroll gains of 235K, and an unemployment rate of 4.7%. Our wage tracker has accelerated to 2.8%. Next week we expect the FOMC will tighten the funds rate by 25 bp (to 0.75%-1.0%) and futures imply an additional two hikes during the remaining nine months of 2017 to roughly 1.4%. The 10-year US Treasury yield equals 2.6% and is marching towards our 3% year-end target.
Continued US economic expansion will lift operating EPS by 13% to $127 by 2019 (adjusted EPS of $134). Our 2500 year-end 2019 target for the S&P 500 represents a 6% rise from the current index level and implies an adjusted forward P/E contraction of 5% to 18x from 19x, consistent with our forecast of higher interest rates. Simply put, only higher profits will support higher stock prices because equity valuations will almost certainly be lower.
Our tactical view remains that S&P 500 has peaked at 2400 and will fade to 2300 by year-end. S&P 500 has rallied by 11% since the election amidst optimism that corporate tax reform will increase S&P 500 earnings. However, investors will soon capitulate on their expectation of upside to 2017 EPS forecasts as they face the reality that the accretive impact from tax reform will not occur until 2018. In fact, revisions to consensus EPS forecasts during the past few months have been negative for both 2017 and 2018. There are only two drivers of stock performance when multiples stop expanding: (1) Earnings growth, and/or (2) expected earnings revisions.