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The Four Questions Goldman's "Confused, Understandably Frustrated" Clients Are Asking

One would think that after last week's market rout, the worst in years, that Goldman clients would have just one question: why just a month after you, chief Goldman strategist David Kostin said to "Buy Stocks Because Hedge Funds Suck; Also Chase Momentum And Beta", are stocks crashing? No really: this is literally what Kostin said in the first days of September: "investors should buy stocks which should benefit from a combination of beta, momentum, and popularity as funds attempt to remedy their weak YTD performance heading into late 2014." Turns out frontrunning the world's most overpaid money losers wasn't such a great strategy after all. In any event, that is not what Goldman's clients are asking. Instead as David Kostin informs us in his weekly letter to Jim Hanson's beloved creations, "every client inquiry focused on the same four topics: global growth, FX, oil, and small-caps."

So while said clients figure out just what the right question is, here are the wrong ones, aka Goldman's damage control:

Policymakers focus on anemic growth in Europe and Japan while US economic and company fundamentals remain strong. Investors should focus on “American exceptionalism” and own stocks with high domestic sales. We forecast S&P 500 will rebound by 7% to reach our year-end target of 2050. Buybacks have been the major source of demand for US equities during the past four years with S&P 500 firms repurchasing more than $1.5 trillion of shares. Peak 3Q reporting season is  the next three weeks. Halloween will be the end of the blackout period for most firms. In recent years, 25% of annual buybacks have occurred in November and December.

 

Conversations we are having with clients: Confusion over growth, FX, oil, and small-caps

 

"Whiplash” is how one veteran investor described this week’s market. S&P 500 fell 1.5% on Tuesday as the IMF’s newest World Economic Outlook discussed the weak prospects for global growth. Wednesday registered 2014’s best daily return (+1.8%) supported by the release of Fed minutes that noted US growth “might be slower than they expected if foreign economic growth came in weaker than anticipated”. The clear implication: Interest rates might be held lower for longer than market participants expected. This comfort was short-lived – S&P 500 sank 2% on Thursday and 1% on Friday.

 

Four topics dominated client discussions this week: (1) The uneven global economic outlook with the US expanding above-trend, China slowing, and Europe barely growing; (2) US dollar strength and a euro rapidly moving towards parity by 2017; (3) the bear market in crude oil with Brent plunging by more than 20% since June; and (4) the dismal returns for US small-cap stocks with the Russell 2000 index lagging by 13% YTD for the largest underperformance vs. the S&P 500 since the Tech bubble in 2000. 

 

Investors are understandably frustrated: More than 85% of large-cap mutual funds have lagged their benchmarks YTD and the typical hedge fund has returned just 1% while S&P 500 has returned 5%. Although realized  volatility surged to 15 in the past month, it has averaged just 10 since the start of the year. The dispersion of three-month stock returns stands at the 1st percentile compared with the past 30 years, and P/E multiple dispersion is near the lowest level in 30 years for the S&P 500 and within many sectors.

 

While policymakers voice concerns about the lack of growth in Europe and Japan, US economic and corporate fundamentals remain strong. Unemployment is at 5.9%, the ISM manufacturing and non-manufacturing indices are both solidly in the expansion phase at 56.6 and 58.6, respectively. S&P 500 margins stand at a record high of 9% and capex is growing by 8%.

As usual here are Goldman's trade recos for the current confused, frustrated environment... of which the Goldman prop desk with take the other side.

(1) Focus on “American economic exceptionalism”. The world lacks growth, but our economists forecast US GDP will accelerate to 3.2% in 2015,  the fastest rate of expansion since 2005.

... re-read that sentence as many times as necessary until you pass out from laughter...

Meanwhile our economists expect Euro area growth of just 0.7% this year and 1% in 2015. US stocks with a high proportion of domestic sales have and should continue to benefit disproportionately relative to firms with a high share of foreign revenues. The performance YTD of US-facing firms (Bloomberg: <GSTHAINT>) versus stocks exposed to Europe (<GSTHWEUR>) totals 1055 bp (+7.5% vs. -3.1%), with 74% of the excess return coming since mid-year (780 bp).

 

(2) Focus on sectors that benefit from lower oil prices. Energy earnings closely follow oil price changes. Brent plunged 20% since June and Energy stocks fell by 11% while S&P 500 slipped only 1%. Without a rebound in crude prices, Energy equities will continue to lag. However, lower oil prices benefit non-energy sectors, particularly Consumer Staples and Discretionary, as input costs decline and personal consumption potentially rises. Other industries such as chemicals and airlines also experience reduced input costs. Investors should overweight Industrials and Consumer Discretionary. 

 

(3) Stick with large-caps despite the siren call of small-cap US equities that have dramatically underperformed. A strengthening US dollar and positive US GDP growth often correspond with Russell 2000 outperformance. However, negative earnings revisions have actually increased small-cap valuations even as share prices have declined. The tight relationship between Russell 2000 relative performance and the slope of the US yield curve highlights the degree to which concerns over growth and Fed policy have biased investors toward the relative safety of large-caps (see Exhibit 4).

 

But, perhaps most important, gone are the days when Goldman could just fall back on the perpetual deus ex of the Fed's rising balance sheet for one simple reason: it no longer is. Instead, Kostin has found a new idol, the same one we revealed in May: behold the god of stock buybacks, who should make everything better:

Open market share repurchases are typically prohibited during the five weeks ahead of the earnings release date. Roughly 75% of S&P 500 firms will report 3Q results between Monday, October 13th and Friday, October 31st. We are now in a blackout period so companies have been precluded from conducting tactical buyback activity that has supported the equity market during sell-offs in the recent past. Roughly 8% of annual repurchases occurs in October compared with 14% in November and 10% in December. We expect a surge in buybacks starting in November which will serve as a tailwind for the stock market during the last eight weeks of the year.

Or... if companies suddenly find themselves unable to issue debt at preferential terms, and/or if the rating agencies suddenly realize that America's "Investment Grade" companies no longer are (recall the scariest chart in IBM's history), and realize that net corporate debt is the highest it has ever been and start serially downgrading IG companies into junk status, watch as Goldman's latest house of cards supporting idol, falls.