After numerous warnings from Goldman strategist David Kostin that stocks are expensive, most recently over the weekend when he wrote that”Goldman strategist 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″ and that “revisions to consensus EPS forecasts during the past few months have been negative for both 2017 and 2018” Goldman officially downgraded equities.
Warning that as a result of rising drawdown risk, a function of the “interplay of the cycle and rates”, with “growth momentum nearing its peak and rates increasing further with a hawkish Fed, the asymmetry for equities is turning increasingly negative.”
This also means more vulnerability to potential shocks, e.g., from European politics, US policy, commodities and China. The increase in risk appetite in recent months and strong positioning by systematic investors such as CTAs and risk parity funds increases ‘vol of vol’ risk, i.e., the potential for a sharp correction.
As a result, “given the asymmetry for equities is getting worse, we downgrade equities to Neutral for 3m. Nonetheless, after what Goldman believes will be an initial flush, stocks will rebound again, and as a result “we remain Overweight for 12m and still see c.5% total return, which is high compared to other assets.”
Here are the highlights from the just released report:
Equity drawdown risk – is the trend still your friend?
Equities had strong risk-adjusted returns in the last 12 n months, trending up with low volatility. The S&P 500 has now increased for more than a year without a 10% drawdown and has had 67 consecutive trading days with 1-month realised volatility below 10%. In fact realised 1-month S&P 500 volatility is at 6.83%, which is the 7th percentile since 1928.
Equity valuations are at their cycle highs and nearing Tech Bubble levels but realised volatility is close to multi-year lows. Investors are increasingly wondering how long this gap can last and if equities will continue their low volatility uptrend. High equity valuations alone are not a reason for drawdowns in the short term, if they reflect stable or improving macro conditions; but they indicate elevated drawdown risk. Current low volatility signals a strong macro backdrop and little reason to worry – but volatility is often a lagging signal.
Risk appetite has picked up again after moderating at the beginning of the year from very high levels in mid-December (Exhibit 1). In our last GOAL report we argued that bullish sentiment and positioning did not have to signal a near-term pullback was imminent, as long as there are no major disappointments. Since then equities have rallied as global growth has accelerated further and several macro indicators have reached new cycle highs (e.g., US jobless claims recently fell to 44-year lows, our global leading indicator (GLI) accelerated to a new 6-year high and our current activity indicator points to global growth of 4%). Macro data has also remained positive relative to expectations, as indicated by our global macro surprise index (MAP) being near a 6-year high as well. The strong performance of the S&P 500 has been closely linked to macro surprises, with it somewhat lagging the better data YTD.
