With standard valuation metrics betraying a market that’s stretched to the breaking point, it’s incumbent upon analysts to find new ways to explain how equities can continue to rise from here. That is of course unless said analysts would rather capitulate and cross over to the bearish “dark side.”
Make no mistake, it’s easy to find cautious sell-side commentary. But most of that commentary seems to be more anecdotal than anything else. That is, you don’t find very many labored attempts to goal seek a lower S&P target. Instead you find these kind of half-hearted efforts to acknowledge absurd multiples and a deteriorating outlook for the reflation meme, efforts that usually end with some kind of quotable soundbite that can be trotted out later if the market does happen to tank as proof that this or that bank wasn’t completely asleep at the wheel.
But when it comes to throwing the kitchen sink at goal seeking targets, those exercises are usually left to someone trying to justify a bullish thesis. We’ve seen this time and again this year (remember Barclays’ “fiscal option“?).
Well with the “hard” data reality still falling well short of the “soft” data euphoria and with Treasurys and the yen looking for any excuse whatsoever to rally, Citi is out with what the bank calls (and this is a quote) “some methodologies used to triangulate” S&P 2,560 by mid-2018. What you’ll read below is hilarious not only because of the blatant attempt to goal seek the outcome, but because of how the bank lapses into colloquialisms and seems to be noticeably irritated with incredulous investors.
The latest driver of anxiety for investors has been the plunge in the CESI, with the S&P 500 linked most closely with the G10 surprise index (see Figure 1), though the cyclicals/defensives trade has been more US-driven (as found in Figure 2). We have argued for years that so many investors do not fully understand the construction of the CESI as it was built by the Citi FX quant team, but it is opined on by Street observers who do not even know its details but assume inaccurate elements about it. The key reasons for the decline were last Friday’s CPI print (which took out 27 points on its own), as well as the NAHB Housing Index, and the Empire Manufacturing figures. Intriguingly, over the past 18 months, there has been a tighter fit between the S&P 500 Industrials sector and the CESI (depicted in Figure 3) and similarly with Materials (presented in Figure 4).
Furthermore, we are told that the lower 10-year yield suggests something is wrong with the economy, but as Figures 5 and 6 illustrate, it is unusual for bond yields to fall when both the unemployment rate is dropping and industrial production is rising. Hence, we are less convinced by the Treasury moves. In addition, the prospective data is still supportive of economic reflation including the ISM new orders data (highlighted in Figure 7) and C&I lending standards (shown in Figure 8). As we have noted many times in the past, industrial activity is significantly correlated with EPS trends and thus looking forward is much more helpful for investors than looking backwards.
With the likelihood for stronger earnings in the quarters ahead, we have initiated a mid-2018 S&P 500 objective with Figure 9 providing some of the baseline methodologies used to triangulate an expected return. Our disciplined process generates a mid-point between the average and median expectation of 2,560, which implies a 9% gain from current levels over the next 14 months. Importantly, when we looked at P/B analysis, we removed any benefit from potential tax cuts in late 2017 or early 2018 in order not to bias the numbers higher. Should the taxes come through, as expected, there could be even more upside to the S&P 500 amidst a doubting Street. The Panic/Euphoria Model is still parked in neutral (highlighted in Figure 10) and client surveys also show uncertainty, although not bearishness. Indeed, were the model to drop into panic territory on any correction phase, we easily could become more excited about returns into mid-2018.
Keep in mind that low inflation trends do not necessarily affect EPS trends as can be seen in Figure 11 and we suspect that investors still do not appreciate the linkage between industrial production and earnings (depicted in Figure 12). Note that CPI trends can impact revenues for Industrials and Energy (seen in Figures 13 and 14). Thus, a pickup in pricing would be welcome but not definitively required. A rebound in business activity would be much more influential.
We find the recent obsession around the US CESI to be fascinating when Figure 15 notes that there have been large dislocations between bond yields and alleged cyclical trends looking back 10 years, yet it is perceived as being important when there is a narrative that needs proof – even if that evidence is kind of sketchy when held under a bit of deeper scrutiny. Moreover, the value/growth decision has no relationship to CESI trends (see Figure 16). But, investors almost seem to want to be misled. As a consequence, we continue to be more focused on the leading indicators which sustain an improving earnings outlook and thereby our upbeat mid- 2018 view.