Goldman Sachs Is Probably Right But Is It Worth The Risk?

February 24, 2017

Goldman Sachs Is Probably Right But Is It Worth The Risk?

  • Goldman Sachs recommends being overweight U.S. equities because of expected loose fiscal policies and because, as they have stated, valuations don’t matter.
  • Goldman expects a 3% yearly return on a moderate risk portfolio.
  • I’ll touch on what the average Goldman client is risking for their 3% yearly return.

Introduction

Goldman Sachs (NYSE: GS) recently released its 2017 market outlook. It shouldn’t be a surprise that the outlook is positive. It’s in their interest for stocks and the economy to continue to thrive as GS makes its money from IPO commissions, asset management fees, etc.

Despite the conflict of interest, their positive outlook will most probably be correct at the end of 2017, but there is something more important than being right or wrong on a yearly forecast.

Today we’ll discuss Goldman’s view and analyze the possible impacts on our portfolios.

Glass Half-Full

Goldman describes the current environment as one of “high market valuations, great policy uncertainty, significant geopolitical tensions and, in all likelihood, an unconventional US presidency.”

Despite the uncertain environment, Goldman remains optimistic about the future and advises being overweight U.S. equities even as valuations have crossed into the 10th decile. Valuations in the 10th decile means that U.S. equities have been more expensive only 10% of the time in the post-WWII period. 72 years have passed since the end of WWII, and stock valuations have only been more expensive in 7 years out of the 72. A look at the S&P 500 chart will show when this was.


Figure 1: S&P 500 10th decile valuations. Source: Multpl.

From a valuation standpoint, the S&P 500 was more expensive only two times in history. In and after the dotcom bubble, and in the 2009 financial crisis when earnings were extremely depressed. If we eliminate the high valuations that were a result of low earnings due to a recession, the only two years where the S&P 500 has been more expensive in history are 1999 and 2000.

So, if Goldman knows stocks are expensive, and they tell us this on the very first page of their 2017 outlook, why are they still bullish? Here are their reasons:

  • “U.S. equities are the best long run asset.”
  • Goldman expects the U.S. to continue to grow through 2017 on the back of a: “looser fiscal policy, relatively easy monetary policy and a less stringent regulatory environment.”
  • “…Expect global growth to improve modestly, from 2.5% in 2016 to 2.9% in 2017, with looser fiscal policy and still easy monetary policy in key countries.
  • Finally, Goldman expects that Trump will do whatever it takes to achieve his desired results even if this means adjusting and changing course on his previous potential market jolting statements.

Goldman concludes by acknowledging “that productivity growth has decreased and labor demographics are less favorable” but nevertheless remains bullish, “A client with a well-diversified portfolio that is fully invested at its US equity allocation is generally well positioned for these uncertain and probably volatile times.

Commentary

My commentary is pretty straight forward. If Goldman’s clients and other investment banks’ clients would start to sell U.S. equities, there wouldn’t be a buyer to absorb such quantities so the only option for Goldman is to remain and always be bullish on the U.S.

On the January 2, 2008, the USA Today collected S&P 500 outlooks from chief investment strategists of major investment banks. The S&P 500 was at 1,322 points, down from the peak reached in June 2007 of 1,526 points. I don’t have to tell you that all the outlooks were extremely bullish, expecting, on average, a 20% return from stocks in 2008.


Figure 2: Investment banks’ outlooks for the S&P 500 in 2008 in points. Source: USA Today.

As you can see above, all the predictions were very similar. This is because as an analyst or strategist, you risk too much, i.e. your job, if you differ from the crowd. Plus, if you aren’t bullish all the time, how are you going to sell your products to your clients? Those who want to know more about how Wall Street works can read our article on why the client is the loser on Wall Street.

With the 2008 projections I’ve shown above, I rest my case. I believe investment firms’ outlooks are just low risk marketing tools. If Goldman and others manage to sustain a bull market, their earnings and subsequent bonuses will remain high for another year.

Screaming to sell your stocks would be equal to suicide for an investment bank. If the market heads down like it did in 2008, well, there will always be the next year to be bullish on. So, the circle continues in eternity.

However, this doesn’t mean that Goldman can’t be right on their 2017 call. There is an extremely high probability that Goldman will be right on their call, like they have been right for the past 8 years. Interest rates are still extremely low enabling the credit economy to continue growing. As long as there is no inflation, interest rates can be kept low and economic growth can be artificially driven through increased credit.


Figure 3: Consumer and motor vehicle loans. Source: FRED.

When you add expected fiscal stimuli coming from the Trump administration to the historically low interest rates, the only way for asset prices to go is up. For now, there is no indication that much will change in 2017 and therefore Goldman will be probably right in their call. Goldman doesn’t see higher interest rates triggering a recession as the U.S. economy is pretty balanced right now. Perhaps 2017 will be the new 1999, which was a very good year for investors.

If Goldman has a high probability of getting it right, what am I ranting about?

Well, first, Goldman’s main reason to be bullish on stocks is because stocks, especially U.S. stocks, have been the best investments in history. In nutrition, such a bias is defined as emotional eating or when you continue to eat the foods you have been eating since you were a child even if those don’t do you any good.

They mention the high valuations, but don’t consider them important at this point in time. The main fact behind Goldman’s bullishness is loose fiscal policies. This is like drinking another beer after a few rounds have already passed in the hopes that it will make you feel even better. Perhaps it will, but as the number of beers (valuations) increase, so does the risk of throwing up (bear market) and having a really bad hangover (recession) afterwards.

Goldman concludes its outlook with the recommendation to stay invested:

While we recommend clients remain invested,” however, they also have modest expectations: “we have modest return expectations. We expect that a moderate-risk well-diversified taxable portfolio will have a return of about 3% in 2017.

Psychological Effect

Goldman’s report is a play on human behavior, especially herd behavior. A recommendation to be overweight in the best performing historical asset, U.S. equities, in the U.S., will hardly raise any eyeballs. Further, describing something unfamiliar like China and emerging markets as extremely risky adds to my thesis. Goldman’s report is focused on keeping its clients happy and feeling safe.

I agree that there is a high probability that Goldman will be correct on their call for a positive 2017 regarding U.S. markets, what I don’t agree with is the recommendation, because I don’t see the estimated 3% return being worth the risk.

Let me quickly explain.

If interest rates increase, both stocks and bonds will fall. If this increase comes in combination with a recession, a global shock, or a run to liquidity, I wouldn’t be surprised to see the S&P 500 drop 50%. A similar thing could happen to bonds as interest rates increase. So, a moderately risky well-diversified portfolio according to Goldman’s recommendations can make 3% in 2017 while according to my risk assessment, it can easily lose 50%. This isn’t a good place to be.

However, I would attach a 90% probability for Goldman being right for 2017 and leave a 10% probability for me being right. In the next 5-years I would give myself a 90% probability of being right as the credit fueled economy can’t grow forever without productivity growth and a 10% chance that Goldman’s scenario continues for another 5 years.

Investing is all about perspective, be sure to be well aware of the potential risks and rewards of your investment decisions in relation to your investment goals and horizon.

P.S. As many investors currently take on the risk of a 50% drop in stocks and bonds, I would advise you to at least look for returns of above 100%. Investing in positive asymmetric risk reward situations is much better than to invest in negative ones like the 3% return and 50% risk that Goldman recommends for 2017.