It’s not immediately obvious that now is the time to get bullish on equities amid a veritable laundry list of geopolitical concerns including, but not limited to, the US election, renewed Brexit worries, and the ongoing “Cold War” between the world’s two superpowers.
In addition to those potential stumbling blocks (and that’s a euphemistic way to describe a trio of events which might more aptly be characterized as “seismic shifts” or “epochal turning points”), stocks have obviously run very far, very fast since the lows in March. Indeed, this has been among the most dramatic rallies in history, both in terms of scope and velocity.
All of that is to say nothing of the rather challenging economic backdrop which, while certainly better than it was five months ago, is still fraught with uncertainty, seemingly underscoring the disconnect between equities and “reality”. And yet, a more nuanced view shows that ex-US stocks and credit have actually stalled — or, at least relative to big-cap, US tech they have.
“After the setback in June, there has been more of a risk-on tone with the S&P 500 making new all-time highs during the summer, but the rally was concentrated on US Tech stocks, which had a sharp correction since then”, Goldman writes, in a new asset allocation piece upgrading equities to Overweight over the next three months (and maintaining stocks at OW over 12 months).
The bank cites better data and vaccine prospects, while acknowledging the myriad challenges in the near-term.
“Growth concerns might linger due to fading US fiscal support and growing election uncertainty, rising COVID-19 cases and delays of vaccines as well as oil price volatility”, the bank says (that’s quite the list), before noting that relative to their own above-consensus outlook for the economy, “growth pricing across and within assets remains conservative”.
Clearly, a vaccine is “still the most important catalyst to drive relaxation on near-term risks and generate growth optimism”, the bank says, but notes that,
Equity risk premia remain elevated and should provide a buffer for rising bond yields with better growth. A strong recovery in earnings growth (global earnings sentiment is now positive) coupled with a lower cost of equity should drive high single digit returns for global equities over a 12m horizon.
Again, the constructive 12-month view isn’t new, but the 3-month Overweight is an upgrade.
A recurring theme in these pages over the past six or so weeks has been that outside of options froth and anecdotal accounts of retail investors treating the stock market like a casino (of course, it is a casino in many ways), evidence of stretched positioning and/or ebullience in equities was pretty scant. For example, SPY saw five straight months of outflows through August, despite the run-up in US stocks.
Goldman underscores this.
“Broad sentiment and positioning do not appear very bullish yet and are well below the levels from February this year or the correction in early 2018”, the bank says, in the course of suggesting that’s one reason to “expect drawdowns to be temporary and less deep”.
The figure (right) gives you an idea of where things stand across positioning versus the beginning of the year, the week of the June 11 rout, and, of course, the March panic lows.
Naturally, Goldman recaps the recent dramatics, again detailing the extent to which options activity helped turbocharge the tech rally via the self-reinforcing gamma loop.
“There were some signs of very bullish positioning in US option markets. After increasing close to all-time highs in March, the US put/call ratio was at all-time lows before picking up in the correction”, the bank writes, before recapitulating as follows:
There was a significant pick-up in demand for call options, in particular for single stocks, where the volumes are at multi-year highs. Options positioning has likely exacerbated both the August rally in US Tech stocks and the recent correction – dealers had to hedge rising delta during the up move and sold into the drawdown (they are short gamma). Before the correction, the VIX, and in particular OTM call option implied volatility, rose alongside equities – historically this has been a warning signal for market fragility (the same was true ahead of the drawdown in March and into 2018). In fact, when bullish option positioning was at comparable levels to now, it has historically been followed by weaker near-term equity returns with lower hit ratios on average.
Again, the point is simply to say that the froth (or the “raging mania” as Stan Druckenmiller put it this week) was largely concentrated in options and FAAMG. There’s still plenty of scope for a pro-cyclical rotation (i.e., for laggards to rally) and for positioning to get more bullish as “left behind” (so to speak) investor cohorts become believers.
But that will be less exciting. “We think that after the sharp rebound in equities, consistent with the ‘Hope’-phase early in a recovery, equity returns are likely to slow as we transition to the ‘Growth’-phase”, Goldman goes on to say, noting that ‘Hope’ is characterized by valuation expansion, while ‘Growth’ is driven by earnings.
The skeptics among you will suggest that earnings aren’t likely to recover to pre-pandemic levels as quickly as many hope, but that’s “what makes a market”, as they say.
In any event, the above doesn’t even begin to scratch the surface when it comes to capturing everything discussed in Goldman’s global asset allocation update, but it sketches the broad contours of the constructive near-term case for stocks despite gale force geopolitical headwinds and domestic unrest stateside.
Of course, the tails are fatter. On the left-side of the distribution, Donald Trump may decide that elections aren’t the best way to determine who is president, ushering in nobody knows what for American politics. As for the right-tail risk, well, we’ve just seen what that looks like with tech’s cartoonish surge.
In recognition of the tails — which the bank defines in terms of “a large gap between valuations and positioning” — Goldman is still Overweight cash.
“After the strong recovery, we still expect a somewhat more ‘fat and flat’ return profile for global equities due to elevated valuations and ongoing growth and inflation uncertainty in the medium-term”, the bank says. “This means the opportunity cost of cash is lower relative to the potential value, especially for investors unable to manage tail risk otherwise”.
