Goldman’s Clients Just Want To Know One Thing: ‘When Will The Rally End?’

Well here we are, another week gone by without a hint of fear or trepidation from a market that is Teflon.

Actually that’s not entirely true. There was a short-lived hiccup as Asia passed the baton to Europe on Thursday. The Hang Seng tumbled out the blue and the tension between Madrid and Catalonia came to a head. But all was well by the close and thanks in no small part to a renewed bout of optimism on tax reform in the U.S., investors were not only no worse for wear, but in fact sent merrily off to the weekend at new record highs.

But people are nervous. Or at least they say they are. Because while everyone is enjoying the ride, there’s a palpable sense that even the most optimistic/punch-drunk market participants realize this has gone on far longer than is explainable by anything other than an appeal to central bank largesse.

In addition to marking the 30-year anniversary of Black Monday, Goldman reminds you that “this week also marked 20 months since the last 10% S&P 500 correction and 16 months since the last 5% drawdown.”

That would be the fourth longest streak in history, the bank goes on to note, behind 17-19 months in 1965, 1994, and 1996 and at 332 trading days is well above the historical average of 92 days. Here’s the chart:

So what are Goldman’s clients asking now that the expansion has run into its ninth year? Simple:

The most common question from clients is, “When will the rally end?”

Good question. And Goldman admits they don’t know any better than you do:

Catalysts for equity market corrections are notoriously difficult to identify ex-ante. In fact, catalysts can even be difficult to identify in retrospect; historians still debate the cause of the Black Monday plunge although portfolio insurance is viewed as the reason the collapse was so dramatic.

But while they can’t tell you when the next drawdown is coming or what will cause it (which are really the only two questions worth answering), they can identify some risks. Here are three:

• Although economic data are extremely strong now, an ISM reading above 60 typically marks the peak of growth and presages economic and equity deceleration. Since 1980, the ISM has exceeded 60 in eight separate episodes; four of those lasted only one month. Investors buying the S&P 500 at ISM readings of 60 or higher have gone on to suffer negative three- and six-month returns on average as economic activity slowed.
• Our economists expect that US GDP will continue to grow at a healthy rate but decelerate from 1H 2017. The anticipated deceleration in economic activity supports our ongoing preference for growth stocks. Companies generating their own earnings growth, such as Information Technology firms and our basket of stocks with the highest Growth Investment Ratios, should continue to be rewarded in an environment of modest economic activity.
• The biggest risk to equity market valuation is rising interest rates. Our economists believe that the Fed will hike in December and four times next year, while market pricing implies 2-3 by year-end 2018. Rising rates should weigh on equity valuations, just as P/E multiples compressed during the last three hiking cycles. However, since the Fed began hiking in December 2015 the S&P 500 forward P/E multiple has expanded by 10% to 18.5x. Rising inflation data or a hawkish shift in messaging from any of the major global central banks could lift long-term bond yields and spark a sharp valuation unwind. Financials should benefit from stronger activity and rising rates.

And as for tax reform, it represents what Goldman calls “the key potential upside and downside risk to equity markets.”

Our political economist sees a 65% probability that tax cuts are passed in early 2018. We estimate tax cuts could lift 2018 EPS by 7% to $148, suggesting that tax reform optimism has contributed to the 5% S&P 500 rally since late August. If developments in Washington lift the odds of tax reform closer to 100%, or hint at larger cuts than we currently expect, S&P 500 could continue to rise toward 2650. On the other hand, a collapse in expectations would likely mean the reversal of the market’s recent 5% rally.

Funny Goldman should say that about how a failure on taxes would be the death knell for the rally. Because as you might recall, one of their most prominent former employees agrees.