Like the festive bird in December, investors may want to ask how much better things can get

While I know nothing about the raising of a turkey before the beautiful bird becomes the main source of culinary jubilation at this time of year, I can imagine that the holiday season must feel like the best days of its life. Well fed, well rested, pleasantly plump, maybe watching some football, probably pretty relaxed—how much better can it get?

As we know, things take a marked and rather sudden turn for the worse for Mr. Turkey. Looking at December’s equity market set-up, should investors ask themselves that same question? How much better can it get?

More Risk Than Acknowledged

I understand the overwhelming sense of optimism for the equity market, based upon an optimistic growth outlook, a subdued interest-rate outlook, tons of potential flow and liquidity on the sidelines in the form of money market cash and an extremely high savings rate, and the sense that there is no other investable alternative.

But markets are not only about the outlook. They are about what is priced in relative to the outlook. And at some point, even the most optimistic outlook gets priced in.

With that in mind, let us examine some simplistic measures of what the equity market is pricing. I stress that while I do not wish to communicate a negative view on equities, I do wish to suggest that there is more risk associated with potential sell-offs in the first quarter of 2021 than I believe is acknowledged in the consensus.


The chart below shows the Goldman Sachs Global Cyclical to Defensive equity basket relative to the yield of the U.S. 10-year Treasury. It’s a simple enough chart, but nonetheless I would argue that it has, since 2015, done a good job of “evaluating” the market’s view on potential future economic growth and signaling its inflection points: see the collapses in January 2016, December 2018 and March of this year, for example.

Figure 1. A Substantial Divergence Between Equity and Bond Market Pricing of Future Growth

Source: Bloomberg. Data as of December 8, 2020. For illustrative purposes only.

“That’s great,” I hear you say, “It’s a pretty picture, but why does this matter?”

Think of these two lines as the two metrics that form the discount rate in a simple Gordon growth model. The 10-year yield is equivalent to the cost of capital or rate of return (r)—CAPM and DDM experts will say that r is not purely a rate, but all else being equal a lower rate lowers true r. Cyclicals over defensives is a good proxy for growth (g). The discount rate is r minus g. A lower r and a higher g, therefore, result in a higher asset value, as the discount factor decreases.

The catch is that, theoretically, as g grows, r typically follows, as r should to some extent reflect longer-term growth outlooks. Very simplistically, this is why the lines in the chart have tended to track each other reasonably well, and why the divergence we have seen this year is significant. It suggests that the equity market currently benefits from the most positive forward-looking estimate of growth relative to 10-year rates in years.

With the Fed on hold until the Great Pumpkin shows up, and with Modern Monetary Theory holding that no stimulus is too large that it cannot be financed by printing Rich Uncle Pennybag’s multi-colored paper (for those who don’t know, he is the mascot of the famous Monopoly game), this makes sense. Or at least, it makes sense until it doesn’t—and let’s not discuss what that means just yet.

Valuation Anomalies

Theoretical debates aside, this is an unusual circumstance and the equity market is pricing it as such. Below is a chart of one-year forward price-to-earnings multiples for the S&P 500 Index. Just as the equity market growth estimate is exhibiting the biggest divergence from long-term interest rates in 10 years, P/E multiples are at a 10-year high as well. We know that the sector mix is different over time, the rate outlook is unique and this sort of thing can continue for a long while… but that line is pretty high, no?

Figure 2. How Much Better Can It Get?

S&P 500 Index one-year forward price-to-earnings multiple, 2010 — 2020

Source: Bloomberg. Data as of November 30, 2020. For illustrative purposes only.

Right now, the consensus for 2021 S&P 500 earnings is $168 per share. At a P/E of 21.5x, that puts the Index at 3,610, pretty much where it is now—implying a 0% return from here. The upper end of earnings estimates is $175 per share, implying a 2.5% return from here. But let’s imagine that earnings revisions continue to head up and that 2022 estimates assume a further 10% growth, to $192.50 per share: a 21.5x multiple would then give us 4,140 on the S&P 500 in six months’ time, or a 12% return. In other words, equity market performance from here will likely be very sensitive to analysts’ earnings revisions.

Just how far can earnings revisions (g) go without any upward movement in rates (r)? Who knows?

Since the Great Financial Crisis, “fading” valuation anomalies—taking the other side of the bullish trade—has seemed like the quickest route to becoming an entrepreneur since the Gold Rush. Just ask those in the macro community who were talking about how ridiculously low Bund yields were in 2012, or who pointed to the virtual “arbitrage” available so many times in paying one year forward Eurodollars as the U.S. unemployment rate approached 5%. Guilty as charged!

Tough to Be a Turkey

So, what is the message?

I am not suggesting you sell your equities or even go underweight. But I do believe the risk of a volatile 2021 is higher than acknowledged. While analogies are dangerous and history only ever rhymes, I think it’s instructive to look back at 2009 – 10 for a comparison.

In 2009, unprecedented policy action rescued the world from an apparent abyss and set up a market rally from March to year-end. I remember from my trading seat at Goldman Sachs how “bulled up” all of us were on the equity floor in December: the growth outlook was strong, policy was exceptionally accommodative and investors were all underweight. Sure enough, 2010 started out strong with a rally that lasted until about January 10. By mid-February the market was down 5% on the year. After another rally in the spring, it slumped to -9% in late June. We finished the year up 10%, but only after trading a 20-percentage-point range.

I believe the probability of a similar market in 2021 is higher than currently being discussed precisely because the market is so dependent on continuing incremental fiscal stimulus, monetary policy accommodation and liquidity. These are the elixirs for the powerful force pushing the equity market ever higher in any and all weather conditions: lower real rates.

In conclusion, I do not wish to push back on the constructive consensus in equity markets just yet, but I do believe it is worth stepping back and considering what is priced in versus that consensus—especially around periods that see strong seasonal flows. Be careful when things seem like they can’t get any better and you are feeling comfortably plump around the holidays.

It can be tough to be a turkey.