The S&P 500 Index (SPX) tumbled 3.9% last week off its record high and was down sharply again on Monday, sparking fears that investors are entering a long-overdue correction of 10% or more, or perhaps a bear market. The biggest pullback in 2017, by contrast, was only 2.8%, according to Goldman Sachs Group Inc. The latest declines have prompted an increasing number of Goldman's clients to ask a whether they should brace for a replay of the 1987 stock market crash, known as Black Monday, when an avalanche of sell orders pushed down the Dow Jones Industrial Average (DJIA) by about 22%. Goldman argues that these fears are overblown, and says there are strong fundamental reasons for continued bullishness, per their current U.S. Weekly Kickstart report.
Goldman points out that 2018 has begun with accelerating GDP growth, rising commodity prices, and a weaker than expected U.S. dollar. All these are combining to drive upward revisions in corporate earnings. Additionally, the report notes that stock price gains so far in 2018 have been driven by increasing EPS, partly the result of corporate tax reform, rather than expanding valuation multiples. Corporate stock buybacks and demand for equities by individual investors also are key factors behind their bullish scenario of 3,000 for the S&P 500, which would represent a gain of 8.6% from Friday's close. Their base case of 2,850 for the S&P 500, meanwhile, equates to a 3.2% increase.
2018 Isn't 1987
Prior to 2018, there have been 12 other years since 1950 in which the S&P 500 gained 5% or more in January, per Goldman, with 5.7% being this year's increase. In those 12 previous years, the median January gain was 7%, and the median gain during the remaining 11 months was 17%, they calculate. The only one of those years in which the market retreated from February through December was 1987, which had a post-January decline of 10%. And Goldman sees 2018 as very different from 1987.
In 1987, there was an overheated market driven by the expansion of valuation multiples, rather than increasing earnings, per Goldman. The S&P 500 was up 13% in January, then tacked on another 20% through August, before diving 20% on Black Monday, October 19, 1987. Nonetheless, Goldman adds, the S&P 500 managed to close out 1987 with a 2% gain.
The year 2018 looks different. Goldman expects the forward P/E multiple on the S&P 500 to remain stable at 18 times EPS. Their bullish case of 3,000 for the index is driven solely by an optimistic scenario for EPS. Goldman expects four rate hikes by the Federal Reserve in both 2018 and 2019, with the yield on the 10-Year U.S. Treasury Note reaching 3.0% by year-end 2018. They forecast that rising interest rates will put the brakes on further expansion of equity valuation multiples.
Goldman examined sector performance for January of 2018, in which the S&P rose 5.7%. The biggest gainers were: consumer discretionary, +8.2%; financials, +7.6%; and information technology, +7.6%. The biggest laggards were: utilities, -4.6%; real estate, -3.7%; and consumer staples, +1.1%. Rising interest rates were the main factor weighing down on utilities and real estate, sectors with high dividend yields that are bond substitutes for income-oriented investors.
Reasons For Caution
There are many reasons for caution even if stocks avoid a meltdown like 1987. Goldman, for example, warns that consensus EPS estimates for full year 2018 may end up being too optimistic, overshooting the actual results. That could cause sharp pullbacks in stocks that miss analysts' rosy forecasts. Goldman also says that the net EPS gains from tax reform may be overestimated, with tight labor markets driving wage increases and battles for market share forcing price cuts.
Meanwhile, the equity futures markets are registering their highest net long positioning since 2007, Goldman notes, which is when the last bear market began. This may be a contrarian indicator. In addition, current stock prices are being propped up, in large part, by a mountain of margin debt. According to Goldman, the ratio of NYSE net margin debt to market capitalization is at its highest since at least 1980.