The major stock market indices continue to set new records uninterrupted by significant pullbacks, an upward march fueled by optimism about President Donald Trump's economic plans. Through February 24, for example, the S&P 500 Index (SPX) has gone 93 consecutive trading sessions without a single-day decline of 1% or more, and the last multi-session fall of 10% or more on the S&P 500 ended over a year ago, on January 20, 2016.
While cautious investors see a significant correction looming, Goldman Sachs Group Inc. (GS) analysts say that history shows the market may be poised for more big gains.
The Aftermath of Long, Stable Markets
In its latest US Weekly Kickstart report, Goldman looked at the six most recent prior instances, from 1985 to 2006, when the S&P 500 went 80 or more trading days without a 1% daily decline. Their median length was 100 days, during which the S&P 500 posted a median return of 13%. Rather than significant corrections, these periods typically were followed by further gains, with median returns over the next 3 months, 6 months and 12 months of 4%, 9% and 15%, respectively.
Moreover, in only two instances were there declines over the succeeding three or six months, and these were 2% or less. In all six cases, there were gains over the next twelve months, ranging from 2% to 34%.
Three Downside Risks
Despite this history, however, Goldman forecasts that the S&P 500 will be essentially flat for the rest of 2017, peaking at 2,400 by the end of March and finishing the year at 2,300, below where it is today.
Goldman sees three major downside risks for the near-term. They anticipate: that corporate tax rate reductions may not take effect before 2018; that the Federal Reserve is increasingly likely to increase interest rates multiple times; and that the winners of the upcoming European elections could be negative for the markets. French Presidential candidate Marine Le Pen of the National Front party, the leader in recent polls, promises to exit the eurozone if she wins the election on April 23.
Additionally, there is the risk that President Trump will start to take concrete actions on his protectionist campaign promises, especially regarding imports from China. His address to a joint session of Congress on February 28 will be closely watched for signals in this regard. Last, Goldman forecasts modest annualized U.S. GDP growth in the range of 2.0% to 2.3% through 2018, far short of what Trump promised during his election camaign. This slower GDP growth would limit upside potential on corporate earnings and share prices.
Hedging With Options
Goldman suggests that one tool investors can use to protect themselves against a 5% decline in the S&P 500 over the next four months is by selling an S&P 500 call option with a strike price of 2,410 and June 30 expiration date, and using the option premium received to buy a put option with a strike price of 2,240 and the same expiration date. The strike price of the latter is approximately 5% below the current value of the S&P 500 index.
Of course, most investors can do little to protect themselves from a traditionally defined correction, which is a decline of 10 percent or more, in the markets. If that happened, the Trump surge since the election may be officially over.