Back in September, Goldman built themselves a bull/bear indicator that rolls up several variables in an effort to effectively divine something about the risk of imminent turning points. Ultimately, they “discovered” that “many bull market peaks were associated with a combination of conditions based on 5 factors”:
- the labor market,
- growth momentum,
- valuation,
- term structure of the yield curve and
- inflation
There’s nothing particularly novel about their approach, but then again, there’s nothing particularly novel about anyone’s approach to trying to time markets and/or identify peaks because to the extent you actually discovered something that was truly unique and/or infallible, no one would know about it because you’d just build an algo based on it, hit “go”, and retire to the Swiss Alps.
So about the best anyone can do with these indicators is check in on them when things seem to be turning and see if they might have some predictive power. As you’re no doubt aware, BofAML’s Michael Hartnett has had more than a little success this year with his own Bull/Bear indicator which correctly flashed a “sell” signal just days before things fell apart in February.
Well in light of last week’s turmoil, Goldman is out with an update on their indicator and it’s still elevated:
But they don’t think you should be jumping off any bridges just yet because if you look at the breakdown, there’s a “wide distribution” (i.e. a couple of factors are skewing things):
Needless to say, the subdued inflation shown there is what’s leading Goldman to believe that things aren’t as precarious as they seem (although really, when three out of five variables are stretched, I’m not entirely sure it’s fair to call that a “wide distribution”).
“It is because of the lack of inflation that some of these variables can appear stretched without ringing alarm bells for equity investors,” the bank writes, adding that “it is very unlikely that without core inflation rising much, policy rates will rise sufficiently in the US or elsewhere to invert yield curves and/or force a recession in the near future.”
All of that centers on cyclical factors. What about structural bear markets or, in simpler terms, what about the possibility that imbalances are lurking around out there and are just waiting to unwind rapidly, plunging markets into a tailspin? On that, Goldman pitches bloated central bank balance sheets as a positive development to the extent they’re not likely to be unwound as quickly as private sector leverage. To wit:
Of course there are other possible causes of equity bear markets that may not be triggered by monetary tightening. In our bear market analysis we looked at different profiles of historic bear markets and their triggers. We found that, in addition to ‘cyclical’ bear markets (largely a function of monetary policy and the economic cycle) there were also ‘structural’ bear markets which are typically triggered by the unwinding of major economic imbalances accompanied by financial bubbles bursting. We believe that the these risks are even lower than the risks of a cyclical bear market. This is partly because we have only recently experienced a structural bear market around the financial crisis but also because the major imbalances that preceded this event have largely unwound, or at the very least shifted from the private to the public sector (and central banks balance sheets) and so reducing the risks of a rapid unwind (see Exhibit 4).
When it comes to imbalances, Goldman references a previous piece they did, highlights from which you can find in “Where The Risks Are: A Spider Web Of Financial Excess.”
Still, they do concede that the QE shown in Exhibit 4 has led to a scenario where everything is stretched to the proverbial breaking point and clearly, that’s dangerous.
They reiterate the point that stocks, bonds, and credit are the most simultaneously expensive they’ve been in damn near a century (if you need a refresher on that, see “The 100-Year Bull Market“), before citing a long list of reasons why equity valuations are not actually as worrying as they appear. For one thing, Goldman notes that thanks to recent drawdowns, things are less stretched. To wit:
The global all share index forward PE is now back to its 30-year average despite the fact that the average 10-year US bond yield (as a benchmark) over this period was 4.6% (and 6% between 1988 and 2008 crisis) and is now 2.8%. The de-rating in equity markets that has continued in recent days on the back of growing trade/growth concerns is evident in exhibit 7.
And then there’s the old RV argument:
While equities look expensive on valuation relative to history, they remain relatively attractive against bond markets. We can see this with our measures of the equity risk premium (ERP) in Exhibit 9. These are closer to long-run averages in the US than elsewhere. But even so, the valuations are not stretched. Another way of thinking about this is to look at what has happened to bond yields and dividend yields since the financial crisis. Europe is a good case in point. Since the start of the financial crisis, 10-year German government bond yields have fallen from around 4.5% down to lows of less than 1%; at the same time, dividend yields have remained broadly unchanged throughout (Exhibit 10). The relative gap has therefore widened in favour of the equity market.
Then there’s an effort to explain that equities aren’t “particularly expensive” if you look at historical correlations with yields:
Exhibit 11 shows the US equity market P/E correlation against 10-year treasury yields. The chart is split into two periods. Prior to the tech collapse (between 1976 – 1998), the correlation was quite high and very clear – lower bond yields justified higher P/E multiples. Since the tech bubble (1999-2018), the relationship has changed. Lower bond yields have been associated with lower multiples than would have previously been the case (as growth and political risks have pushed up the ERP). But the current multiple seems to be ‘fairly’ placed relative to this more recent relationship. Arguably, if growth and political concerns are fading, the more ‘typical’ correlation between the level of bond yields and valuations might begin to reassert itself. Put another way, the ERP could fall. The same is true in Europe (Exhibit 12).
There’s a ton more (this is a 20 page ordeal), but you get the idea. It’s an exercise to explain away high valuations and as is usually the case when you’re engaged in a long-winded effort to “prove” something and you’re working with a lot of smart people and a lot of data, you can do a pretty good job in the goal seeking department. That’s not to disparage the analysis, it’s just to point out the obvious. They knew what they were after here.
The bottom line for Goldman is that despite their Bull/Bear indicator sitting at a lofty 70% (which typically telegraphs risks ahead), a full-on bear market isn’t likely around the corner.
According to Goldman, what you want to watch out for is rising core inflation that would entail more hawkishness from the Fed. And I guess what I would note there is that this just represents what’s becoming a pretty deeply ingrained propensity to believe that somehow, late cycle dynamics in the economy are not ultimately going to feed through to rising wages and inflation pressures more generally. That view was enshrined in the SEP this month as the Fed now sees only a modest overshoot on inflation even as the unemployment path was aggressively revised lower. Fingers crossed the old models are as dead as everyone thinks they are.
