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One year ago, we reported
that in its attempt to calculate the likelihood, and timing, of the next
bear market, Goldman Sachs created a proprietary “Bear Market Risk
Indicator” which at the time had shot up to 67% – a level last seen just
before the 2000 and 2007 crashes – prompting Goldman to ask, rhetorically, “should
we be worried now?”
While Goldman’s answer was a muted yes, nothing dramatic happened in the
months that followed – the result of Trump’s $1.5 trillion fiscal stimulus
which pushed the US economy into a temporary, sugar-high overdrive – aside
from the near correction in February which was promptly digested by the
market on its path to new all time highs (here one has to exclude the rolling
bear markets that have hit everything from emerging markets, to China, to
commodities to European banks).
At the time, Goldman wrote that it examined over 40 data variables (among
macro, market and technical data) and looked at their behaviour around major
market turning points (bull and bear markets). Most, individually, did not
work as leading indicators on a consistent basis, or they provided too many
false positives to be useful predictors. So the bank developed a Bear Market
Risk Indicator based on five factors, in combination, that do provide a
reasonable guide to bear market risk – or at least the risk of low returns:
valuation, ISM (growth momentum), unemployment, inflation and the yield
curve.
And, as Goldman’s Peter Oppenheimer explained, while no single indicator
is reliable on its own, the combination of these five seems to provide a
reasonable signal for future bear market risk.
All of these variables are related. Tight labour markets are typically
associated with higher inflation expectations. These, in turn, tend to
tighten policy and weaken expectations of future growth. High valuations, at
the same time, leave equities vulnerable to de-rating if growth expectations
deteriorate or the discount rate rises, or, worse still, both of these occur
together.
To aggregate these variables in a signal indicator, we took each variable
and calculated
its percentile relative to its history since 1948. For the yield curve and
unemployment
we took the lowest percentiles relative to history, while for the other
indicators we took
the highest. We then took the average of these.
Fast forward to today, when one year later Goldman has redone the analysis
(and after what may have been some prodding from clients and/or compliance,
renamed its “Bear Market Risk Indicator” to “Bull/Bear
Market Risk Indicator”) where it finds that the risk of a bear market – based
on its indicator – is now not only nearly 10% higher than a year ago,
but well above where it was just before the last two market crashes, putting
the subjective odds of a crash at roughly 75%, well in the “red line” zone,
and just shy of all time highs.
Or as Goldman puts it, “Our Bull/Bear market indicator is flashing
red.”
While one can argue with the subjective interpretation of this heuristic,
a tangential analysis shows that Goldman’s indicator is inversely correlated
with future returns, and as of this moment, Goldman is effectively
forecasting a negative return from now until 2023.
Here even Goldman’s Oppenheimer admits that “the indicator is at
levels which have historically preceded a bear market. Should we
take this seriously? It’s always risky to argue that this time is different
but there are two most likely scenarios when we think of equity returns over
the next 3-5 years.”
Or, in other words, “how worried should we be about a bear market?”
Goldman’s answer is two-fold, laying out two possible outcomes from here, either
a sharp, “cathartic” bear market, or just a period of
slower, grinding low returns for the foreseeable future. Naturally,
Goldman is more inclined to believe in the latter:
- A cathartic bear market across financial
markets. This has been the typical pattern when this indicator
has reached such lofty levels in the past. It would be most likely
triggered by rising interest rates (and higher inflation), reversing the
common factor that has fuelled financial asset valuations and returns
over recent years or a sharper than expected decline in growth. Such a bear
market could then ‘re-base’ valuations to a level where a new strong
recovery cycle can emerge.
- A long period of relatively low returns across
financial assets. This would imply a period of low returns
without a clear trend in the market.
With retail investors still rushing to buy whatever institutional
investors have left of offload in the very late innings of the longest bull
market in history (and with Fidelity’s zero cost ETFs making it especially
easy to do that), Goldman does not want to spook its clients into selling,
and writes that “several factors suggest that a flatter return for longer may
be more likely.” They are as follows:
i) Valuation is currently the most stretched of the factors in the
Indicator – other factors such as inflation appear more reasonable.
This is largely a function of very loose monetary policy and bond yields (see
Exhibit 45).”
ii) Inflation and, therefore, interest rate rises have played an
important part in rising bear market risks in past cycles. Structural
factors may be keeping inflation lower than in the past, and central bank
forward guidance is reducing interest rate volatility and the term premium. Without
monetary policy tightening much, concerns about a looming recession – and
therefore risks of a ‘cyclical’ bear market – are lower. So long as
the Phillips curve remains as flat as it is now, strong labour markets can
continue without the risk of a recession triggered by a tightening of
interest rates. While this has not happened before in the US (and hence the
economic cycle has not lasted more than 10 years), there have been examples
of other economies experiencing very long economic cycles where the
unemployment rate moved roughly sideways for many years.
Our economists have shown that there are good examples of long expansions,
such as in Australia from 1992 to the present, the UK from 1992 to 2008,
Canada from 1992 to 2008 and Japan from 1975 to 1992. Typically they find
that a flatter Phillips curve, stronger financial regulation and a lack of
financial imbalances are all good indicators that a long cycle is more
likely. On this later point, the signs are quite positive.
In the case of the US, our economists point out that a passive fiscal
tightening, tighter financial conditions and supply constraints are likely to
leave growth at 1.6% in 2020, below potential, leaving a greater risk of at
least a technical recession in 2020-2021. But this is not their base case and
their model (which uses economic and financial data from 20 advanced
economies to estimate recession odds) puts the probability of a US
recession at under 10% over the next year and just over 20% over the next two
years, below the historical average.
iii) Aligned to this point, we can see that inflation targeting
and independent central banks have both contributed to lower macro volatility
and longer expansion phases in economic cycles since the 1980s.
So on the surface, while admitting we are overdue for a crash, Goldman
spins the narrative into positioning what happens next not as a crash, but as
a period of lower returns, adding that a sharp bear market in the
absence of a recession is unlikely, and that generally equities rise
when economic growth is positive:
… using US equity market data, the probability of negative annual equity
returns falls dramatically as real GDP (lagged by 2Q) rises. So, for example,
the probability of negative year-on-year returns when real GDP is between 1%
and 2.5% is just 31%.
Or, in other words, “the absence of a trigger for a sharp economic
downturn suggests that, while this cycle may have been the weakest in the
post-war period, it is likely to be the longest. This, together with lower
private sector imbalances, may reduce the prospect of a sharp bear market
anytime soon.”
That’s the good news. The not so good news, is that as Goldman admits,
with monetary and fiscal policy having thrown everything at the 2008 global
financial crisis, “even if the next economic downturn turns out to be mild,
it may prove difficult to reverse.” As a result, we may go back to an
environment dominated by concerns over secular stagnation, for which Goldman
lists two reasons:
- The US has already expanded fiscal policy and
its debt levels and budget deficit are rising, which could make it
difficult to find room for significant easing. The federal
deficit will increase from $825bn (4.1% of GDP) to $1,250bn (5.5% of
GDP) by 2021. By 2028, it is expected to rise to $2.05 trillion (7.0% of
GDP). This would leave federal debt at 105% of GDP in ten years, 9pp
higher than CBO’s latest projections.
- There may be room for US interest rates to be cut in the
next downturn but less so than in other downturns. Also,
European interest rates may still be at or close to zero when the next
US downturn hits. The same would be true for Japan.
In other words, while Goldman’s indicators suggest a crash is imminent,
the bank redirects the discussion to a period of low returns and secular
stagnation, which while eliminating the threat of an imminent collapse
presents even greater concerns about investing in the current market.
Most ominously, the bank admits that “the combination of
constrained fiscal policy headroom in the US and limited room to cut interest
rates in Japan and Europe may well dampen the ability to generate a strong
coordinated policy response to any downturn, and also make it harder to get
out of such a downturn.”
Said otherwise, whether the next crash is sharp and “cathartic” or slow
and extended, the problem is what happens next, because as even Goldman now
admits, the ammo to kickstart the US and global economy has already been used
up.
