It has now become a weekly ritual: Goldman warns the market is overvalued and poised for a selloff, market proceeds to ramp to new all time highs.
It was just last weekend when Goldman’s chief equity strategist, David Kostin warned that investors will soon realize they were too optimistic, pointing out that the “S&P 500 has returned 10% since Election Day while consensus 2017E adjusted earnings have been lowered by 1%”, and adding that “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.”
What happened next is familiar: the Dow proceeded to notch five consecutive all time high in the following week, closing at a new record on Friday afternoon.
So has Goldman thrown in the towel? Not at all, and in a note over the weekend, Kostin is now clearly perplexed by what he dubs a “relentless bull market”, is now making not only short-term predictions, but urging Goldman’s clients to “replace long equity positions with calls or sell unlikely upside to fund protection.”
Some more details: in a note from Friday evening, asking “How to position in a relentless bull market given a long list of near-term drawdown“, Goldman observes that “It has been a year since the last 10% US equity market drawdown but long periods of stability are not good indicators of drawdown risk. In recent years, investors have bled premium by hedging positions while stocks continued to climb. Looking ahead, the distribution of market outcomes appears asymmetrical. Near-term downside catalysts include (1) investor recognition that lower corporate tax rates may not take effect until 2018; (2) multiple Fed hikes; (3) European elections. We forecast S&P 500 will peak in 1Q at 2400 and end the year at 2300. Given extremely low volatility, investors should replace long equity positions with calls or sell unlikely upside to fund.”
In short, while Goldman’s top equity strategist is perplexed (or at least so he would like to appear, even though virtually all of Trump’s economic advisors are his former colleagues and Goldman’s stock has soared over 30% since the election), his advice is for clients to get out in the next 5 weeks (when Q1 ends), and to “replace long equity positions” while selling unlikely upside to take advantage of the extremely low volatility.
Below are the details of Goldman’s latest bearish thesis:
“August in February” describes both the weather and trading activity this week. As temperatures in Manhattan climbed into the high 60s (20º C), equity volatility continued to fall. S&P 500 realized 3-month volatility now ranks in the 1st percentile of the last 50 years. It has been more than two months since S&P 500 moved more than 1% intraday. Earlier this month marked a full calendar year since the last 10% US equity market drawdown. The S&P 500 declined by 14% in February 2016. It has been more than seven months since the last 5% drawdown (6% in June 2016), and 93 trading days – more than four calendar months – since the S&P 500 last experienced a daily decline of 1% in early October. The last time the market exceeded that stretch was 94 days in 2006.
Long periods of market stability are not good indicators of drawdown risk. Since 1980, there have been only six instances of the S&P 500 trading for 80 or more consecutive days without a 1% decline. Following the end of these stable market periods, the S&P 500 actually registered a positive three-month return in five of six episodes, with a median 6-month return of 9% and a 12-month return of 15% (Exhibits 2). In short, following previous periods of market stability, the S&P 500 usually continued to march higher.
Extreme positioning of US equity investors is generally a contrarian indicator, but the market has continued to climb amid widespread bullishness. Our Hedge Fund Trend Monitor published this week showed that hedge funds currently carry their highest net long exposure since 2015. Similarly, our Sentiment Indicator based on S&P 500 futures positions reads a 100 this week on a scale of 0 to 100.
Although the indicator is more useful in signaling market upside following low values, readings above 90 have been statistically significant indicators of modest downside risk during the subsequent month. The S&P 500 has continued to reach new record highs despite SI readings above 90 for nine of the last 10 weeks.
The clearest potential tailwinds for S&P 500 upside include government policy and acceleration in US economic data, but neither catalyst looks likely. Investor optimism in recent months has been driven in large part by hopes for lower corporate tax rates. However, our Washington, D.C. analyst believes the political climate suggests that tax reform likely will not go into effect in 2017. Meanwhile, recent economic data have been strong, but the high level of our economists’ MAP index of data surprises as well as the 3.6% pace of US economic growth signaled by their Current Activity Indicator place a high bar for upcoming data releases to maintain the current pace of economic acceleration and drive further share price appreciation.
The distribution of market outcomes appears asymmetrical in our view, but the market will likely continue to grind higher until a catalyst sparks a drawdown. Upcoming weeks include a number of major risks:
- US government policy: Next Tuesday, Feb. 28, President Trump will present his State of the Union to Congress. Trade with China has been notably absent from recent headlines despite constituting a central pillar of his campaign. Protectionist trade policy is a risk lurking under the surface.
- US monetary policy: Although most investors expect two or three FOMC rate hikes this year, the market prices just a 22% likelihood of a hike at the FOMC meeting on March 15. PCE inflation data released on March 1, Chair Yellen’s planned speech on March 3, and/or the monthly jobs report on March 10 could raise the odds of a hike sooner than is currently expected.
- European elections. In a busy calendar of European elections, the first round of the French presidential election will occur on April 23, with a potential run-off scheduled for May 7.
Fund managers are currently caught between a long list of risks and a market climbing steadily to new record levels.
Our 2017 outlook remains that S&P 500 will peak in 1Q at 2400 and then fade to 2300 by year-end. Firms will not benefit from lower tax rates until 2018 and the Fed’s bias is to tighten. But following years of watching cash and hedges drag on returns, it is difficult for investors to miss out on potential upside or spend premium for protection in a market that continues to grind higher. Although European implied volatility shows a “kink” around the French elections, US equities reflect little to no implied risk from the events listed above. Unfortunately, drawdowns rarely announce themselves to investors in advance.
Investors seeking to own US stocks while protecting against upcoming risks can take advantage of extremely low volatility by replacing cash equity holdings with calls. Call options offer unlimited upside participation but risk just the cost of the option if the market falls or stops rising. Investors who are already long but find themselves concerned with the asymmetric risk profile can sell unlikely upside to protect against drawdown risk. An investor can sell a 2410 (+2%) S&P call with a June 30 expiry and use the premium to buy a 2240 (-5%) put. This strategy protects investors from a drawdown of 5% or more during the next four months while allowing participation to our upside forecast level of 2400. June 30 expiry captures the potential event risks listed above as well as the June 14 FOMC meeting. Our economists assign a 90% probability of at least one Fed hike by then while futures imply a much lower 67% likelihood.