The Goldman Sachs Research Note Wasn’t Really Bearish

One of the “reasons” for Monday’s sell-off was a “bearish” research note on stocks from Goldman Sachs.  While that did make for attention-grabbing headlines, the research note itself wasn’t really bearish.  After all, it’s hard to be bearish on stocks when you reiterate a year-end price target in the S&P 500 of 1,900, more than 3% higher from here.

But, the note was cautious, which is what we said in Monday’s Report, as that was the prevailing mood in the market on the eve of earnings season.

In particular, Goldman’s Chief Strategist David Kostin pointed out the well-known fact that stocks aren’t cheap on a forward P/E basis (15.1X 120 ’14 EPS).  But, rather than imply the market is wildly overvalued, he instead took issue with the fact that there seems to be a consensus expectation for multiple expansion to simply lead the market higher again in 2014, as it did in 2013.

Kostin pointed out that a lot of clients and colleagues expect multiples to continue expanding to 17X, 18X or even 20X forward earnings (which would be 2,040, 2,160 and 2,400, respectively, in the S&P 500).  So, if anything, there’s some overvaluation in people’s expectations, not in the actual market.

And, that’s a fair criticism, because as Mr. Kostin noted, markets trading in that 17X – 20X forward earnings range has only happened twice over the last 30+ years.  So, his voice of caution about market valuations—and, more importantly, the growing expectation of further multiple expansion—is warranted based on history.

But, that doesn’t mean he’s bearish, as the note was so often referred to yesterday.  Instead, he correctly points out, as I did in yesterday’s Report, that the onus for stocks to move materially higher from here is now on earnings.  Last year, the market rallied on multiple expansion as the macroeconomic horizon cleared and the global economy began to recover.  Stocks rose from about 12X forward earnings (historically low) to 15X earnings (historically elevated).

This year, if we’re going to see another big move higher in stocks, it’ll be because the “E” in the P/E ratio begins to increase.  So, the S&P 500 won’t have $120 of earnings; it’ll have earnings of, say, $132 (10% earnings growth).  That, based on a 15X multiple, would mean an S&P 500 target of 1,980.

Bottom line is, as the macroeconomic horizon has cleared, we are starting to see a shift in interest back toward fundamental valuations. The main point of the GS note wasn’t to “pooh-pooh” stocks; it was to correctly point out that this year it’s earnings growth, not multiple expansion, that has to lead markets higher. So, this year, it’s all about earnings.

Bottom Line

Yesterday’s rally was a nice response to the Monday sell-off, but it’s simply not fair to discount the Monday drop because of low liquidity and participation and not do the same to the Tuesday rally.

Lack of volumes and participation remain the key influence on the markets on a day-to-day basis, and until we get some sort of clarity from earnings season (which will start to happen next week), I expect a range-bound, but likely volatile, market.

Interestingly, though, as I mentioned yesterday, the market does seem to be constructing a “Wall of Worry” around earnings. And, I read several places yesterday that most traders expect a “17” handle on the S&P before 1,850.  So, sentiment is again cautious.

I’m by no means a perma-bull, and if earnings season isn’t good, then we’re in for some trouble.  But, the relentless skepticism toward this rally remains an underappreciated tail wind. Until we see otherwise, the path of least resistance remains higher, and I wouldn’t be de-risking ahead of earnings.