Despite a strong rally in stock prices that has restored some confidence in the market, Goldman Sachs is advising investors to build their levels of cash now. "The potential exists for further equity market downside in the near term even if the recent equity market collapse does not lead to a recession,” says Goldman's recent Macroscope report, pointing out that cash positions are at their lowest in 30 years. That sober outlook is reflected by investors. Fourth-quarter sell-offs reduced their equity allocation to 41% at the start of this year, the lowest since 2016.
Goldman's concern is fueled by concern that the market could face the same reversal seen in four markets since the 1940s, per the table below.
Why To Raise Cash: Goldman’s Concerns
- Four bear markets without a recession since 1946
- Average S&P 500 decline was 21% over eight months in these four episodes
- History suggests that the S&P 500 could fall further in the next few months
Source: Goldman Sachs
Significance For Investors
Goldman’s overall outlook is bullish. They believe that “recession fears are overdone and that the U.S. economy will continue to expand at an above-trend pace.” They also “expect that US economic growth will support continued earnings growth.” Additionally, they anticipate that stock market valuations will recover, adding another impetus for increased share prices in 2019. Based on their forecasts of 6% EPS growth for the S&P 500 in 2019, plus an increase in its forward P/E ratio to 16 times next 12 month earnings, they forecast that the index will reach a value of 3,000 by the end of 2019.
Nonetheless, they also recommend that investors raise their cash balances and reduce their allocations to bonds, partly based on their projection that the yield on the 10-year U.S. Treasury Note will rise to 3%. The report says: "Uncertain Fed policy, ongoing trade tensions, and liquidity concerns pose risks to our 2019 baseline forecast. Even after the sell-off, cash allocations are likely still near the bottom of their 30-year historical distribution for many investors."
While Goldman expects continued U.S. economic growth in 2019, they advise investors to be wary of potential risks. They write: "If economic growth slows to below 1% or the unemployment rate rises sharply, history suggests that a recession could start in the subsequent 2 to 4 months. Other signs of rising recession risk include a sharp rise in private sector financial balances, a continued rotation into cash, an ISM Manufacturing index below 50, and flat industrial production."
Goldman's cash recommendation appears to reflect the firm's effort to be cautious even though its base forecast calls for a strong stock rally in the face of rising Fed rates, the possible continuation of a trade war, and rising prices that could further squeeze corporate profits. Should a sudden reversal occur, high cash levels could cushion the impact.