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Goldman 'Explains' This Is Not A "Low Quality" Rally, It Is "Macro-Free" - So Don't Worry

It appears even Goldman Sachs was surprised by the recent rally in US equities - especially in light of the explicit hawkishness of The Fed yesterday. In a trading note this morning, the bank says that market risks are real and rising (but are not overwhelming) as it explains, we assume with no intent at humor or sarcasm, that they "prefer to think of the recent equity rally as 'macro-free' rather than 'low quality'," reiterating their view of the cycle and of markets as "fundamentally upbeat." They do, however, admit over the last month, the likelihood of a drawdown in the US equity market further increased, and remains at mildly elevated levels.

via Goldman Sachs,

Market risks: real, but not overwhelming

Despite worries from some that recession risks are on the rise, equity markets continue to recover from their late-August drawdowns. The S&P 500 has recovered around 9pp relative to the trough on August 24 and now stands less than 2pp below its all-time high from five months ago. Chinese equities have seen a similarly good performance over the last two months, breaking a three-month-long slide and recovering some lost ground, although they remain well in the red year-to-date. European equities are also up, after bottoming slightly later relative to other parts of the world.

Our view of the cycle and of markets remains fundamentally upbeat, and we continue to focus on three pillars of support: strength in the service sector, and accommodative monetary and fiscal policy. So, in some sense, we see the resolution of late-summer worries as consistent with our view of the market landscape. Yet, there are still lingering risks and sources of concern. If these resolve, they could provide a further boost to assets, but if they intensify, they could jeopardise gains. Below, we briefly discuss three specific risks: the perceived low quality of the recent rally, a heightened likelihood of equity sell-offs, and the continuing trend of macro data weakness.

Markets recover from the late-summer swoon without much help from macro

In our conversations with clients, a phrase 'low-quality rally' is often mentioned. To a large extent, we think this may be too harsh a judgement, and would argue that 'low-quality', 'risk-on' and 'macro-free' may be close to synonymous. Perhaps not surprisingly, the current rally mirrored the preceding decline. After the August sell-off, we argued that the decline was largely a 'risk-off' move without much macro backing (see Global Markets Daily: Bull market interrupted, September 3, 2015). The same can be said about the recovery. The 'fear factor', as represented by the VIX index, is sharply down, and broad equity indices, including the S&P 500, China and, to a lesser extent, Europe, are up. But most of our growth gauges, including global growth, US domestic growth and European growth, are either flat, or lower. This mostly extended their lukewarm moves during the August sell-off, as it was similarly broad-based and without distinctive macro content. And our measures of the 'macro focus', or the portion of the cross-section of market returns explained by macro factors, is also in the low range relative to history, suggesting that recent market shifts were not motivated by changing views of the macroeconomic landscape.

As Noah Weisberger has discussed, there are some signs that the equity market may be re-focusing on pricing the view of growth a bit higher. If this trend continues, it is possible that some of the hard-hit and still-lagging baskets, including Wavefront Consumer Growth basket and Wavefront Housing basket, may recover some further ground.

Likelihood of drawdowns remains elevated

Market drawdowns are characterised by sharp and swift repricing of the market lower, and the August episode was a textbook example. We argued in the past that these episodes – often broad-based and with little or no macro profile – tend to be relatively short-lived, and followed by periods of relatively steady recovery. In a recent Global Economics Weekly (see Life after a drawdown, October 7, 2015), we presented a simple model for estimating a likelihood of a drawdown within a given month, based on the measure of global growth, realised market volatility, the level of financial conditions and occurrence of drawdown episodes in the proximate past.

Over the last month, the likelihood of a drawdown in the US equity market further increased, and remains at mildly elevated levels (see Exhibit 1). But contributions to this estimate from the factors that participate in the model were mixed. Financial conditions and volatility both eased, and this should have eased the likelihood of a drawdown as well. But global growth (as measured for example by our GLI index) deteriorated further in September, pushing the likelihood of a drawdown higher. And, finally, the fact that there was a drawdown episode in a nearby month also hurt prospects of a drawdown-free month.

There are three aspects of this observation worth underscoring. First, without another drawdown episode, one of the factors that drove the probability estimate higher – the presence of a drawdown in the proximate past – will mechanically disappear with the passage of time. Second, our near- to medium-term view of global growth calls for a gradual stabilisation, and not a substantial further deterioration. If this view materialises, improvements in the GLI's growth and acceleration will help reduce the likelihood of repeated market corrections. And third – and harking back to the notion of 'a glass more than half-full' – is our oft-repeated observation that, over last two years or so, market swoons turned out to be opportunities and not harbingers of lasting market damage (see Exhibit 2).

Growth should stabilise despite ongoing macro data weakness

Both risks described above – the perceived 'low quality' of the recent rally, and the heightened likelihood of equity market drawdowns – are to some extent a consequence of a relatively weak macro data picture. But, here too, there are some mitigating factors. First, as discussed by Francesco Garzarelli in yesterday’sDaily, the weakness is mostly concentrated in the manufacturing sector. Indeed, the most recent read of GLI components suggests continuing strength in consumer confidence, and the US labour market remains robust. Second, there are some faint signs both of US macro data improvements, and also the market’s reaction to these improvements over last few weeks. Finally, our economists' view remains that global growth will stabilise and, in particular, that US growth will remain at around 2.25%.

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So have no fear American investors, despite nothing behind this rally, keep buying (or holding) - because the professionals need someone to sell to...

As you will notice the only "net buyers" of equities have been "individuals," while "professional" firms have been "net sellers." This is the epitome of the classic "smart money/dumb money" analysis where individuals are used by institutions to offload positions that are no longer optimal. 

The question is with corporate profits and earnings declining, weak economic data, and the threat of tighter monetary policy - will individuals once again be left "holding the bag" while institutions derisk portfolios in advance of the next decline?