Goldman’s 2018 S&P Outlook Is Here: ‘Irrational’ Versus ‘Rational’ Exuberance

Apparently, everyone is going to adopt on an oxymoron when describing their outlook for equities in 2018.

As noted last week, there’s something not quite right about the term “rational exuberance.” “Exuberance” implies at least a little bit of irrationality in most cases and there is most assuredly some irrationality inherent in being “exuberant” about an asset class that is stretched to historical extremes on all kinds of standard metrics.

But here’s the thing: assuming the ubiquitous “Goldilocks” narrative of decent global growth but still subdued inflation continues to be a reasonably accurate description of economic reality and assuming subdued inflation gives central banks the cover they need to keep the pace of normalization sufficiently gradual, there’s a plausible argument to be made that risk assets have further to run.

Against the backdrop, Goldman is out with their 2018 equity outlook and it includes the following S&P forecasts for the next 3 years:

Our S&P 500 year-end forecasts are 2850 (2018), 3000 (2019), and 3100 (2020) for gains of 11%, 5%, and 3%.

Their 2018 outlook hinges on three things:

1. above-trend US and global economic growth
2. low albeit slowly rising interest rates
3. profit growth aided by corporate tax reform likely to be adopted by early next year

The bank is calling for a 14% increase in S&P EPS next year assuming tax reform passes. If tax reform fails to pass, well then Goldman sees a 5% near-term drop in stocks.

Goldman concedes that valuations are stretched on both an absolute and a relative basis. To wit:

After a nine-year rally, stocks now trade at lofty valuations relative to history on both an absolute and relative basis. S&P 500 has returned more than 350% (a 19% annualized total return) since the index bottomed in March 2009. Both the aggregate S&P 500 index and the median stock trade at extremely elevated P/E, P/B, EV/Sales, and EV/EBITDA multiples. Similarly, government bond yields on both a nominal and real basis are low (implying high valuation) and credit spreads for both investment-grade and high yield bonds are tight by historical standards.

Additionally, Goldman thinks they hear “echoes” of the 1990s bull market:

Stocks soared during the nine years following the 20% collapse on ‘Black Monday’ October 19, 1987. From its December bear market low through 1996, the S&P 500 index delivered a total return of nearly 330% (17% annualized), just slightly behind the magnitude of the current rally. Both economic expansions were long lasting (ultimately lasting 120 months in the 1990s while the current expansion stands at 100 months and counting). Subdued inflation contributed to the extended equity bull markets during both periods.

That comparison of course sets up the Greenspan quote:

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?”

Ok, so having set the stage, Goldman moves to show you the difference between their “rational” exuberance and the “irrational” exuberance that culminated in the tech bubble. Here’s the chart:

See how that works? It’s not irrational exuberance now, because Goldman’s targets are not as aggressive as what unfolded from December 1996 to March 2000. Obviously, there’s no logic to that at all, but there is some logic in what follows:

The current equity market valuation is certainly stretched in historical terms but it does not appear unreasonable based on the high level of corporate profitability. The return on equity (ROE) of the S&P 500 equals 15.4%, which typically corresponds with a price/book multiple of roughly 3x. The index currently trades at a modest premium of 3.3x. Looking ahead we forecast ROE will expand to 17.5% in 2018, supporting an increase in valuation from the current level.

As far as multiples go, here’s the chart shown above with forward P/Es:

The gist of Goldman’s argument is that this is increasingly going to be a market that’s driven by earnings and not by multiple expansion. This has been echoed by any number of analysts of late and I’m willing to bet Deutsche Bank’s Binky Chadha is nodding his head in agreement with the following additional excerpt from Goldman’s outlook:

An earnings-driven bull market is inherently rational for a fundamental equity investor. Decomposing the building blocks of a rally allows an investor to differentiate between what has a foundation of stone and what is a castle in the air. Between 1987 and 1996, the S&P 500 index was lifted by roughly 30% from P/E multiple expansion and 70% from earnings growth. The components of the current bull market that started in 2009 are similar: Valuation expansion has accounted for about 30% of the rally, profit growth about 50%, and the remaining 20% from an increase in expected EPS growth. In contrast, more than 50% of the market rise between 1996 and 2000 came from a dramatic P/E multiple expansion and less than half came from higher earnings. We believe the current modest upward trajectory can continue because less than 10% of the projected return from today through 2020 will come from valuation expansion.

Ok so given that, you can probably surmise what Goldman thinks would be a warning sign that irrationality has taken over once again. To wit:

We would deem it “irrational exuberance” if the S&P 500 during the next three years followed the exponential trajectory of stocks in the late 1990s. In that situation, the S&P 500 would trade at 5300 by year-end 2020 (a 105% rise from today). If stocks instead trade at a similar forward P/E to the Tech Bubble (24x).

And while all of that is fine and good, the most important (and also the most self-evident) passage from the entire note is this one:

Unfortunately, it is only in retrospect that one can definitively establish that assets have reached unsustainable levels.

Yes… “unfortunately.”