Tag Archives: Goldman Sachs

A string of worst evers

As the COVID19 deaths peak, in the first wave at least, across much of the developed world the narrative this week has moved to exit strategies. The medical situation remains highly uncertain, as the article in the Atlantic illustrated. A core unknown, due to the lack of extensive antibody testing, is the percentage of populations which have been infected and the degree of antibodies in those infected. What initially seemed to me to be a reasonable exit framework announced by the US has been fraught with execution uncertainty over the quantity and quality of the testing required, exasperated by the divisive ramblings of the man-child king (of the Orangeness variety).

The economic news has been dismal with a string of worst ever’s – including in retail sales, confidence indices, unemployment, energy and manufacturing. The number of turned over L shaped graphs is mind-blowing. And that’s only in the US! The exhibit below stuck me as telling, particularly for an economy fuelled by consumer demand.

In the words of the great Charlie Munger: “This thing is different. Everybody talks as if they know what’s going to happen, and nobody knows what’s going to happen.” The equally wise Martin Wolf of the FT, who penned an article this week called “The world economy is now collapsing” posted a video of his thoughts here. His article was based upon the release of the latest IMF economic forecasts, as below.

The IMF “baseline” assumes a broad economic reopening in the H2 2020. The IMF also details 3 alternative scenarios:

  • Lockdowns last 50% longer than in the baseline.
  • A second wave of the virus in 2021.
  • In the third, a combination of 1) and 2).

The resulting impacts on real GDP and debt levels for the advanced and emerging/developing countries respectively are shown below.

A few other interesting projections released this week include this one from Morgan Stanley.

And this one from UBS.

And this one from JP Morgan.

In terms of S&P500 EPS numbers, this week will provide some more clarity with nearly 100 firms reporting. Goldman’ estimates for 2020 compared to my previous guestimates (2020 operating EPS of $103 versus $130 and $115 in base and pessimistic) were interesting this week given the negative figure for Q2 before returning to over $50 for Q4. The “don’t fight the fed” and TINA merchants amongst the current bulls have yet to confront the reality of this recession for 2021 earnings where the fantasy of an EPS above $170 for 2021 will become ever apparent with time in my opinion. Even an optimistic forward multiple of 14 on a 2021 operating EPS of $150 implies a 25% fall in the S&P500. And I think that’s la la land given the numbers that are now emerging! We’ll see what this week brings…..

Stay safe.

Bye-bye buy the dip

As my previous post illustrated, I got caught up with the notion that the fall in the equity market of late was an opportunity to buy into some names in the expectation that we’d go higher into year end. It’s clear that the classic “buy the dip” strategy that has worked so well in recent years, well, doesn’t work anymore. The graph below, from a report by equity strategist Michael Wilson of Morgan Stanley, has been widely cited to illustrate the failure of the strategy in 2018.

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Wilson commented that “such market behaviour is rare and in the past has coincided with official bear markets (20 percent declines), recessions, or both.” There is much discussion amongst commentators about whether we are entering, or indeed have entered, a bear market. I like the simplicity of the argument by Peter Oppenheimer, another equity strategist this time at Goldman Sachs. Oppenheimer argues that a decline in corporate profits in 2019 implies a recession in the US and as a recession is unlikely in 2019, he expects corporate profits to continue to grow, albeit at a much-reduced pace.

As pointed out by Wilson, we will not know the answer about where corporate profits are going until firms report Q4 and guide for 2019. He did also say that equity analysts are always slow off the mark as they wait for firms to reluctantly report on bad news. The after the fact downgrades on NVDA are testament to that! With some commentators calling the bottom around 2,550 to 2,600 on the S&P500, it looks unlikely that there will be any major upside in the market until there is more clarity on Fed policy and the trade issues with China.

If the market moving up depends upon Fed Chairman Powell indicating a policy change to “one and wait” or for a breakthrough at the G20 on trade, then I think we’ll go down further or, at best, sideways. If there is some modest indicator that the pace of interest rate rises in 2019 will be data dependent from Powell and the G20 meeting results in a short-term cease-fire between the US and China, then markets could find a bottom and stabilize. Whatever about the likelihood of the Fed rescuing the market (unlikely in my opinion), I fear that any meaningful relaxation in US-China tensions is against the play-book of the Orange One in the White House. The rhetoric from side-kick Pence at the weekend with language indicating China was leading other Asian countries into debt bondage does not bode well for next week’s G20 summit.

On China, I really like Ray Dalio’s explanation of the fundamental difference between the Chinese and US system (here is just one example of his latest thoughts), being a top down versus a bottom up approach. As Dalio explained it, the Chinese place an importance on family and paternal direction as opposed to the US adoration of the individual above all else. Unfortunately, I doubt that the current US leadership has the intellect to nuance a workable resolution between these two philosophies.

Following on from the analysis in this post on peak quarterly earnings, the current market narrative is that the EPS estimates for 2019 and 2020 will come down over the coming months. Currently S&P is showing a 11% projected increase for 2019 operating EPS for the S&P500 (13% on a reported EPS basis). The current market jitters indicate the market view those figures as unrealistic. Oppenheimer indicated that Goldman Sachs is currently thinking about a 6% and a 4% growth in EPS for 2019 and 2020 respectively is more realistic. Wilson indicted Morgan Stanley are projecting EPS growth for 2019 in the low single digits.

Given that estimates usually increase over time in the good years and decease in the bad years, I am going to assume a 3% and 1% increase in operating EPS for 2019 and 2020 respectively in this no recession but slowing growth scenario. Given that forward multiples would also decline in such a slowing environment (I have assumed to a modest 14), I estimate year-end targets for the S&P500 for 2019 and 2020 of 2,500 and 2,300 respectively, a decline of 6% and 13% respectively over the S&P500 today! The graph below shows the scenario as described.

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Economies generally don’t have slow gentle soft landings, it’s nearly always turbulent. Just look at the chart above to see how improbable the gentle scenario is compared to history. We need a major boast, such as a comprehensive resolution of the US-China trade issue, to maintain the bull market. Otherwise, I suspect the great EPS growth party is over.

Interestingly, Morgan Stanley also highlighted the headwind of quantitative tightening, as per the graph below, on the current market fall. I last discussed this issue in this post in January.

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No more buy the dip for a while yet I fear…….


Clearly wrong

Back at the end of July, in this post on artificial intelligence (AI), I highlighted a few technology stocks related to AI that may be worth looking at in a market downturn. I named Nvidia (NVDA), Google/Alphabet (GOOG) and Baidu (BIDU). Well, I followed through on two of these calls at the end of October and bought into GOOGL and NVDA. I am just still too nervous about investing in a Chinese firm like BIDU given the geopolitical and trade tensions. I am reasonably happy about the GOOGL trade but after their awful results last night I quickly got out of NVDA this morning, taking a 17% hit.

Last quarter CEO Jensen Huang said the following:

A lot of gamers at night, they could — while they’re sleeping, they could do some mining. And so, do they buy it for mining or did they buy it for gaming, it’s kind of hard to say. And some miners were unable to buy our OEM products, and so they jumped on to the market to buy it from retail, and that probably happened a great deal as well. And that all happened in the last — the previous several quarters, probably starting from late Q3, Q4, Q1, and very little last quarter, and we’re projecting no crypto-mining going forward.

Last night, they guided their Q4 gaming revenue down sequentially by a massive $600 million, about a third, to clear inventory of their mid-range Pascal GPU chips and warned that the crypto hangover could take a few quarters to clear. CEO Jensen Huang said “we were surprised, obviously. I mean, we’re surprised by it, as anybody else. The crypto hangover lasted longer than we expected.” That was some surprise!!

All the bull analyst calls on NVDA have been shown up badly here. Goldman Sachs, who only recently put the stock on their high conviction list, quickly withdrew them from the list with the comment that they were “clearly wrong”! My back of the envelop calculations suggest that the 2019 and 2020 consensus EPS estimates of $7.00 and $8.00 pre-last night’s Q3 results could be impacted down by 15% and 20% respectively. Many analysts are only taking their price targets down to the mid to low $200’s. With the stock now trading around the $160s, I could see it going lower, possibly into the $120’s if this horrible market continues. And that’s why I just admitted defeat and got out.

All bad trades, like this NVDA one, teach you something. For me, its don’t get catch up in the hype about a strong secular trend like AI, particularly as we are clearly in a late market cycle. NVDA is a remarkable firm and its positioning in non-gaming markets like data-centres and auto as well as the potential of its new Turing gaming chips mean that it could well be a star of the future. But I really don’t understand the semi-conductor market and investing in a market you really don’t understand means you have to be extremely careful. Risk management and sizing of positions is critical. So, don’t get caught up in hype (here is an outrageous example of AI hype on Micron).

Strangely, I find it a physiological relief to sell a losing position: it means I don’t have to be reminded of the mistake every time I look at my portfolio and I can be more unemotional about ever considering re-entering a stock. I don’t think I will have to consider NVDA again for several quarters!

Lesson learned. Be careful out there.

Broken Record

Whilst the equity market marches on regardless, hitting highs again today, writing about the never-ending debates over equity valuations makes one feel like a broken record at times. At its current value, I estimate the S&P500 has returned an annualised rate of nearly 11%, excluding dividends, since its low in March 2009. As of the end of September 2017, First Trust estimated the total return from the S&P500 at 18% since March 2009, as per the graph below.

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Goldman Sachs recently published an analysis on a portfolio of 60% in the S&P 500 and 40% in 10-year U.S. Treasuries, as per the graph below, and commented that “we are nearing the longest bull market for balanced equity/bond portfolios in over a century, boosted by a Goldilocks backdrop of strong growth without inflation”. They further stated that “it has seldom been the case that all assets are expensive at the same time—historical examples include the Roaring ‘20s and Golden ‘50s. While in the near term, growth might stay strong and valuations could pick up further, they should become a speed limit for returns”.

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My most recent post on the topic of US equity valuations in May looked at the bull and bear arguments on low interest rates and heighten profit margins by Jeremy Grantham and John Hussman. In that post I further highlighted some of the other factors which are part of the valuation debate such as the elevated corporate leverage levels, reduced capital expenditures, and increased financial risk taking as outlined in the April IMF Global Financial Stability report. I also highlighted, in my view, another influential factor related to aging populations, namely the higher level of risk assets in public pensions as the number of retired members increases.

In other posts, such as this one on the cyclically adjusted PE (CAPE or PE10), I have highlighted the debates around the use of historically applicable earnings data in the use of valuation metrics. Adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation) are just some examples of items to consider.

The FT’s John Authers provided an update in June on the debate between Robert Shiller and Jeremy Siegel over CAPE from a CFA conference earlier this year. Jeremy Siegel articulated his critique of the Shiller CAPE in this piece last year. In an article by Robert Shiller in September article, called “The coming bear market?”, he concluded that “the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets”.

The contribution of technology firms to the bull market, particularly the so-called FANG or FAANG stocks, has also been a much-debated issue of late. The graph below shows the historical sector breakdown of the S&P500 since 1995.

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A recent article from GMO called “FAANG SCHMAANG: Don’t Blame the Over-valuation of the S&P Solely on Information Technology” tried to quantify the impact that the shift in sector composition upon valuations and concluded that “today’s higher S&P 500 weight in the relatively expensive Information Technology sector is cause for some of its expensiveness, but it does not explain away the bulk of its high absolute and relative valuation level. No matter how you cut it, the S&P 500 (and most other markets for that matter) is expensive”. The graph below shows that they estimate the over-valuation of the S&P500, as at the end of September 2017, using their PE10 measure is only reduced from 46% to 39% if re-balanced to take account of today’s sector weightings.

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In his recent article this month, John Hussman (who meekly referred to “his incorrectly tagged reputation as a permabear”!!) stated that “there’s no need to take a hard-negative outlook here, but don’t allow impatience, fear of missing out, or the illusion of permanently rising stock prices to entice you into entrusting your financial future to the single most overvalued market extreme in history”.

As discussed in my May post, Hussman reiterated his counter-argument to Jeremy Grantham’s argument that structurally low interest rates, in the recent past and in the medium term, can justify a “this time it’s different” case. Hussman again states that “the extreme level of valuations cannot, in fact, be “justified” on the basis of depressed interest rates” and that “lower interest rates only justify higher valuations if the stream of future cash flows is held constant” and that “one of the reasons why reliable valuation measures have retained such a high correlation with subsequent market returns across history, regardless of the level of interest rates, is that the impact of interest rates and growth rates on “terminal” valuations systematically offset each other”.

Hussman also again counters the argument that higher profit margins are the new normal, stating that “it’s important to recognize just how dependent elevated profit margins are on maintaining permanently depressed wages and salaries, as a share of GDP” and that “simply put, elevated corporate profit margins are the precise mirror-image of depressed labour compensation” which he contends is unlikely to last in a low unemployment environment.

Hussman presents a profit margin adjusted CAPE as of the 3rd of November, reproduced below, which he contends shows that “market valuations are now more extreme than at any point in history, including the 1929 and 2000 market highs”.

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However, I think that his profit margin analysis is harsh. If you adjust historical earnings upwards for newer higher margin levels, of course the historical earning multiples will be lower. I got to thinking about what current valuations would look like against the past if higher historical profit margins, and therefore earnings, had resulted in higher multiples. Using data from Shiller’s website, the graph below does present a striking representation of the relationship between corporate profits (accepting the weaknesses in using profits as a percentage of US GDP) and interest rates.

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Purely as a thought experiment, I played with Shiller’s data, updating the reported earnings for estimates through 2018 (with a small discount to reflect over-zealous estimates as per recent trends of earnings revisions), recent consensus end 2018 S&P500 targets, and consensus inflation and the 10-year US interest rates through 2018. Basically, I tried to represent the base case from current commentators of slowly increasing inflation and interest rates over the short term, with 2018 reported EPS growth of 8% and the S&P500 growing to 2,900 by year end 2018. I then calculated the valuation metrics PE10, the regular PE (using trailing twelve month reported earnings called PE ttm), and the future PE (using forward twelve month reported earnings called PE ftm) to the end of 2018. I further adjusted the earnings multiples, for 2007 and prior, by applying an (principally upward) adjustment equal to a ratio of the pre-2007 actual  corporate profits percentage to GDP divided by a newly assumed normalised percentage of 8.5% (lower than the past 10-year average around 9% to factor in some upward wage pressures over the medium term). The resulting historical multiples and averages are shown below.

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Based upon this analysis, whilst accepting its deeply flawed assumptions, if 2018 follows the base case currently expected (i.e. no external shocks, no big inflation or interest rates moves, steady if not spectacular earnings growth), the S&P500 currently looks over-valued by 50% to 20% using historical norms. If this time it is different and higher profit margins and lower interest rates are the new normal, then the S&P500 looks roughly fairly-valued and current targets for 2018 around 2,900 look achievable. Mind you, it’s a huge leap in mind-set to assume that the long-term average PE is justifiably in the mid-20s.

I continue to be concerned about increasing corporate leverage levels, as highlighted in my May post from the IMF Global Financial Stability report in April, and the unforeseen consequences of rising interest rate after such a long period of abnormally low rates.

In the interim, to paraphrase an ex-President, it’s all about the earnings stupid!

Crimping CDS

The post-crisis CDS market has undergone significant regulatory change including a substantial regulatory overhaul due to the Volcker Rule, requirements from reporting to central clearing under the Dodd–Frank Act and the European Markets Infrastructure Regulation (EMIR), and Basel III capital and liquidity regulations. Measuring the size of the market consistently is notorious difficult given different accounting treatments, netting protocols, collateral requirements, and legal enforceability standards. Many organisations have been publishing data on the market (my source is the BIS for this post) but consistency has been an issue. Although a deeply flawed metric (due to some of the reasons just highlighted and then some), the graph below on the nominal size of the CDS market (which updates this post) illustrates the point on recent trends.

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The gross market value (defined by BIS as the sum of the absolute values of all open contracts with either positive or negative replacement values) and the net market value (which includes counterparty netting) are better metrics and indicate the real CDS exposure is a small fraction of the nominal market size, as per the graph below.

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Critics of the regulatory impact on the liquidity of the CDS market argue that these instruments are a vital tool in the credit markets for hedging positions, allowing investors to efficiently express investment positions and facilitating price discovery. A major issue for liquidity in the market is the capital constraints imposed by regulators which impedes the ability of financial institutions to engage in market-making. The withdrawal of Deutsche Bank from the CDS market was seen as a major blow despite some asset managers and hedge funds stepping up to the mark.

The impact of rising interest rates in the coming years on the credit markets will likely have some interesting, and potentially unforeseen, consequences. With a plethora of Goldman Sachs alumni currently working on Trump’s “very major hair cut on Dodd-Frank”, amongst other regulations, it will be interesting to see if any amendments lead to a shot in the arm for the CDS market. Jamie Dimon, in his most recent shareholder letter, calls for an approach by Trumps’ lieutenants “to open up the rulebook in the light of day and rework the rules and regulations that don’t work well or are unnecessary”.


June 2020 Update – Below is the CD graph updated to the end of 2019. For Ingrid.