‘We’re At The Opposite End Of A Stock Super-Cycle’: Goldman

Earlier this month, while raising their year-end target for the S&P, BofA suggested US equities might be in for a lost decade.

If that sentence sounds familiar, that’s because it’s verbatim from an article published here last week documenting one way the bank thinks investors might avoid languishing in equity purgatory for the next 10 years.

I bring it up again Monday because Goldman was out with a new strategy paper outlining the bank’s longer-term view for equities. It’s a lengthy affair and apparently constitutes the first in a three-part series on what the bank’s calling the “post-pandemic cycle.”

On the off chance you’ve ever perused one of Goldman’s global strategy papers (the latest installment marks number 49), you know they’re not generally amenable to summary treatment. This one is a bit more conducive to a quick take, though.

After suggesting the post-World War II history of US equities is actually a story of “three long ‘super cycles,'” the bank’s Peter Oppenheimer returned to a familiar concept: The “fat and flat” trajectory, in which aggregate returns are “low but positive” and “punctuated with large cyclical swings.”

He identified a trio of reasons that together argue for lower returns on the index: Valuations, low rates and high margins.

BofA’s Savita Subramanian reiterated this month that valuation “is almost all that matters for long-term stock returns.” For his part, Goldman’s Oppenheimer noted that “higher valuations imply either greater risk of a correction/bear market, or a sustained period of low returns in the future.” He used R-squared between Shiller CAPE and 10-year future equity returns (left figure, below).

Consistent with Subramanian’s chart, the predictive power of valuations decreases materially on shorter horizons. Once you get down to two years, for example, it may as well not matter at all.

Oppenheimer also pointed to a familiar chart (on the right, above) of equity market cap as a percentage of global GDP in noting that “the current cycle is unusual as it is starting with high valuations for equities and other asset markets, primarily owing to historically low interest rates [which] again suggests more muted aggregate future returns.”

Next, Goldman helpfully noted that “it’s difficult to exaggerate how low interest rates and bond yields are from a historical perspective.” To make the point, the bank used the BOE’s dataset to make their own version of a chart that BofA’s Michael Hartnett is fond of citing. Goldman’s “only” goes back to 1314 (below).

The read-through is simple enough: It’s hard to see how the trajectory can continue along that path. If it doesn’t, “equity (and bond) investors are not going to enjoy the benefit of consistently higher valuations driven by a fall in the risk-free rate,” to quote Oppenheimer.

Finally, there’s margins which, you’ll recall, hit a record in Q2, just a year on from the worst economic collapse since The Great Depression (figure below).

I scarcely need to enumerate the myriad potential headwinds to profits, but just in case, you might cite soaring input costs (“transitory” or not), wage pressures, a push to stop the global “race to the bottom” on corporate taxes and the generalized sense that corporate profits need to be reined in, lest your “tired, poor, huddled masses” reach the absolute limit when it comes to being patient with various manifestations of inequality, including and especially the almost total annihilation of labor as an economic actor with sufficient leverage to advance its own interests.

“While it remains possible that margins could rise further as a result of further innovations and increased productivity, it is unusual for margins to have recovered to pre-recession highs as quickly as has been the case in the current cycle,” Goldman’s Oppenheimer said, after spending a few pages discussing the various dynamics that have driven margins over the decades.

The bank sees margins leveling off and “becoming more stable” versus the previous cycle. That also suggests a flatter return profile for equities at the index level.

Goldman continued for another dozen pages (give or take), but the bottom line was relatively straightforward. “We are now at the opposite end of a ‘super cycle’, with record low interest rates and inflation expectations, and high valuations and margins,” Oppenheimer remarked, on the way to suggesting that “many of the tailwinds for equity returns enjoyed in recent decades are unlikely to be repeated and may even start to reverse to some extent.”

And that, as they say, is that.