Goldman: “The Last Time The Market Acted Like This Was At The Tech Bubble Peak”
Yesterday’s dramatic “rotational” divergence between tech stocks and the rest of the market, which as Sentiment Trader pointed out the only time in history when the Dow Jones closed at a new all time high while the Nasdaq dropped 2% was on April 14, 1999, stunned many and prompted Bloomberg to write that “a crack has finally formed in the foundation of the U.S. bull market. Now investors must decide if any structural damage has been done.”
This year’s hottest stocks, companies from Facebook Inc. and Apple Inc. to Netflix Inc. and Nvidia Corp., buckled Friday, spurring losses that sent the Nasdaq 100 to its biggest drop relative to the Dow Jones Industrial Average since 2008.
An alternative explanation is that the purge in tech stocks, responsible for half the market’s gains in 2017…
.. was long overdue, and followed not only virtually every hedge fund piling into tech stocks in the first quarter, resulting in the tech sector becoming the “most overweight it has ever been” according to Bank of America, but also followed the biggest weekly outflow from the tech sector XLK ETF in over a year.
Ten days ago we highlighted a quote from Miller Tabak’s Matt Maley who said “everybody remembers 2000, so they might be getting a little nervous with this development. I just wonder how many people have said to themselves, ‘If AMZN gets to $1,000, I’m going to take at least some profits.’” to which we said “and another question: now that the first sellers have emerged, will the herd follow…”
So what prompted the unexpected tech crash rotation, and AMZN flash smash?
There were plenty of theories, some pointing to a bearish tweet by Citron’s Andrew Left who complained about “frenzied casino action” in Nvidia. A previously discussed report by Goldman Sachs which warned about an “air pocket in tech valuations” did not help, although the most likely reason was a long-overdue rotation out of growth/momentum stocks which as we showed one week ago, has trounced the “value” factor in 2017.
Incidentally the right question is not what caused the selloff, but what prompted the unprecedented pile up into tech stock to begin with, something RBC’s Charlie McElligott has been warning about for months.
Overnight, Goldman’s chief equity strategist also opined on the matter, piling on some more gloom for tech bulls, and warning that while the “economic environment has proven just right for Technology and other secular growth stocks” the “perfect fairy tale scenario for tech is unlikely to last” amid signals inside the market point to slowing growth.
Discussing the shifting economic outlook in 2017, which started off with a bang on hopes of a Trump-driven reflation, which has seen been fully unwound amid fears of a deflationary bust, Kostin says that the unexpected mix of healthy growth and declining rates represents a Goldilocks scenario for US equities.
Growth data has certainly not been too cold, supporting S&P 500 EPS growth of 14% in 1Q and consensus expectations for 11% growth in both 2017 and 2018. Nor have conditions run too hot and caused the rise in rates that we expected would constrain equity valuations this year. Instead, the economic backdrop has proven just right.
However, the current “Goldilocks” scenario – not only for tech stocks but the broader market – also carries with it the seeds of its own destruction according to Goldman, which maintains its year end target for the S&P at 2,300 or 5.5% lower from here.
As Goldman cautions, “just like in the fairy tale, this perfect scenario is unlikely to last. With the economy at full employment, an easy Fed risks the possibility that wage pressures build and weigh on corporate profit margins. Our base case is that above-trend economic growth will eventually push inflation higher, prompt an accelerated pace of Fed tightening, and lead to higher bond yields that will reduce equity valuations. As the cycle matures, we expect US equity prices will continue to rise, but we think that the trajectory of price gains will be slower than the pace of earnings growth as monetary policy and valuation multiples each normalize.”
That’s the upside scenario. Goldman also concedes there is an alternative world in which it is wrong about growth and inflation picking up:
Conversely, if the current market outlook for low rates and inflation is proven correct, it will likely accompany a significant slowdown in the pace of economic growth. This scenario is potentially less friendly for equities given the negative earnings revisions that likely would result from a weakening economic environment.
Kostin admits that so far the market finds itself in the latter camp, as “the outperformance of NDX, “FAAMG” (FB, AAPL, AMZN, MSFT, and GOOGL) and other growth stocks also supports the idea of decelerating economic growth” and explains “growth stocks typically outperform when there is a scarcity of economic growth. This cycle’s prolonged length and slow economic growth help explain why value stocks have underperformed growth stocks to such a large extent during recent years and YTD in 2017.”
There is more confusion. Last week we again showed that, in a paradoxical outcome, the Fed’s 2 recent rate hikes have resulted in the loosest financial conditions observed since 2014.
As Deutsche Bank calculated, the Fed’s “tightening” since the December 2016 FOMC meeting is the equivalent to one 25bp rate cut, even though the Fed has raised twice over this period.
Kostin touches on this divergence too, and writes that “perhaps most remarkable is the outperformance of stocks with strong balance sheets alongside a rallying equity market and extremely easy financial conditions. Falling rates, tight credit spreads, a slipping USD, and high equity prices have brought the Goldman Sachs Financial Conditions Index to its lowest level in two years.”
To Goldman this is a puzzle, as its basket of S&P 500 firms with Strong Balance Sheets (GSTHSBAL) has outperformed its Weak Balance Sheet basket (GSTHWBAL) by 520 bp during the last six months.
As Kostin explains outperformance of strong balance sheet companies – usually tech-linked names that have little or no debt and substantial cash flow – in a 10%+ equity market rally is rare; occurring in only 5% of six-month stretches in the last 30 years.
The punchline: “the last such notable episode was in 2000, at the Tech Bubble peak.”
Of course, it is worth noting that Goldman is axed in this trade because if there is anything that will send the S&P sliding and hitting Goldman’s year end target of 2,300 it is a selloff in tech (and other strong balance sheet companies), which as noted above, are responsible for half the market’s YTD gains.
And while normally we would caution that the Fed may simply step in during any concerted selloff amid the broader market (catalyzed by the tech sector) as it has every single time in the past, this time it may let gravity take hold: after all, not only did the Fed caution during its last FOMC minutes that elevated asset prices have resulted in “increased vulnerabilities” and that “asset valuation pressures in some markets were notable“, but as Goldman also warned recently, Yellen may be looking for just the right “shock” with which to reaffirm control over a market which is now interpreting a rate hike as an easing signa (see “Goldman Asks If Yellen Has Lost Control Of The Market, Warns Of Fed “Policy Shock“).
It is hardly a secret that most Goldman recommendations in recent years have a been a dud, but just maybe this time it is different. The bank’s long-suffering clients – most of whom find themselves on the opposite side of the bank’s prop trading desk – will certainly be grateful.