Will it be The Grinch or Santa this Year?

• Goldman Sachs turn bullish – targeting a 20%+ gains for 2021
• The long-term relationship between stocks and inflation
• Why the gold price has stalled the past 3 months

There are just 43 days to Christmas (or 42 if you are in Australia) 

I’m in the process of mentally preparing to spend Christmas Day in a Sydney “Hotel Jail” (i.e. quarantine)… which sounds like fun! Feel free to send me your best hotel room workout routines for 14-days.

Another conversation… 

The S&P 500 is up 10.5% year-to-date.

The Nasdaq is up over 30%.

If we can finish anywhere near today’s close – it will be considered a solid year – despite a 35% bump-in-the-road over March.

So here’s today’s exam question: 

Will the market be higher or lower as we close out the final two months?

My guess – within 3% of where we are today (i.e. flat). For example, a range of 3400 to 3700 on the S&P 500

But it’s just a guess…  

From mine, it’s hard to be the “grinch” given the trillions in free money coming down the pike – supported by the prospects of a vaccine in 2021.

What could go wrong?

Higher rates? Unlikely in just two months. Maybe late in 2021.

That said, a lot of the good news (e.g. vaccine, recovering economy, gridlock in Congress) is already priced in.

But that’s not Goldman Sachs’ view… 

They were out today with a target of 3700 for the S&P 500 this year (3.6% higher than today’s close) – with targets of 4300 for 2021

Goldman Sachs’ Santa Rally

According to this report at Yahoo!Finance – Goldman have now turned very bullish.

The number crunchers at Goldman Sachs are bullish on how a COVID-19 vaccine could impact the stock market.

 

Very bullish, to put it mildly.

 

Goldman’s chief strategist David Kostin hiked his year-end S&P 500 price target by 4% to 3,700 on Wednesday. The lift comes after a surge in the market this week following upbeat news Monday from Pfizer in the race to develop a COVID-19 vaccine. That surge has taken the S&P 500 to 3,570 — so Kostin is looking for a good deal more upside as other players such as Moderna (MRNA) release trial data soon.

 

“A vaccine is a more important development for the economy and markets than the prospective policies of a Biden presidency. The much-awaited results from Pfizer (PFE) that its COVID-19 vaccine has an efficacy rate greater than 90% is a positive event that will allow society to gradually normalize during 2021,” Kostin writes.

 

Kostin sees the equity rally at the hands of vaccine distribution continuing into 2021. The strategist projects the S&P 500 rising 16% to 4,300 by the end of 2021 and recommends investors buy deep value stocks. He thinks the S&P 500 will reach 4,600 by the conclusion of 2022.

That’s a big vote of confidence in not just the economy… but also expected stimulus measures, the Fed and monetary policy, company valuations, interest rates and inflation (more in this in a moment)

Just the other day – I offered an upside target for the S&P 500 of 3800 if it could break through overheard resistance.

S&P 500 – Nov 11 2020 – Potential 3800 Target

From mine, whilst I think their end of year target of 3700 is certainly possible – 2021 deserves a closer look.

For example, if we are to realize 4300 next year (i.e. a ~23% rally)  – a lot of that will not only depend on a strong re-opening and stimulus – but also what we see from rates and inflation. 

For example, according to this analysis from Ben Carlson – inflation plays a major role in how equities perform. 

With inflation below 3% – which is what we have seen the past decade or so – risk assets are likely to perform far better. 

And I suspect that’s what we will see next year… 

However, when inflation creeps above 3% (in turn which attracts higher rates) – stocks do not perform as well. 

Ben adds:

 “… disinflationary periods have been shown to benefit the stock market while rising inflation is seen as a negative. So an economic boom combined with above-average inflation could eventually become a risk to the stock market. And higher inflation would be bad for the bond market as well because rates are so low and fixed income investors are punished during inflationary environments.”

So what do we see with core PCE inflation today (and the Fed’s preferred measure) 

Core PCE Inflation – Nov 11 2020 – Well Below 2.0%

As we know – the Fed will continue with their pedal-to-the-metal stance until they see this sustained well above 2.0%

And they might get it… but for now there is not much risk of inflation in the near-term.

Ben’s article stated that when inflation has been in the 2-3% range historically, the S&P 500 has seen an average yearly return of 20.6% and a median return of 21.6%. Here’s the yearly return breakdown by inflation rate from 1928-2019

And maybe this is what Goldman see… inflation just above 2%. 

So will we See Inflation? 

Maybe.

We don’t know. 

We have never chartered waters like these.

If you have a GPS – let me know. I could use it!

Now inflation is caused by excess cash in the system chasing too few goods. 

I am reasonably certain of the latter (due to supply chain issues) – but is there excess cash in the real economy?

Not yet. 

But this will mostly depend on what velocity banks are willing to lend (and in turn consumers spend) 

It’s not happening yet – but again – it could change. 

Now if I look at 5-Year TIPS yields – they don’t see too much inflation coming down the pike.

For this less familiar – TIPS are indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value

5-Year TIPS – Nov 11 2020

If there is a risk of inflation on the horizon – expect these yields to rise.

Yields and Gold

One reader reached out yesterday and asked about whether rising bond yields also explain the subdued gold price. 

The answer is yes. 

And it can be shown one of the best correlations in all of finance… 5-Year TIPS (inverted) vs Gold

5-Year TIPS (Yellow Inverted LHS) vs Gold (Blue RHS)

For clarity, 5-Year TIPS yields have been inverted – shown on the left-hand axis.

In other words, they are almost negative 1%

Now if we go back to 2016 – they were almost +1.5% (i.e. we were in good shape)

But as these yields plummeted (i.e., bond price rose) – the gold price took off

Let’s look up close…. which highlights the recent 3-month “stall” we have seen with the gold price: 

5-Year TIPS (Yellow Inverted LHS) vs Gold (Blue RHS)

The yellow line shows how 5-Year TIPS yields have improved slightly from August… 

And look at what we see with the gold price… its stellar run also paused. 

In summary, if yields continue to improve then expect this to put a lid on the gold price. 

I found it interesting that Goldman are so bullish on the next 12-24 months.

Approx 20%+ next year (after 28% in 2019 and potentially 10-12% in 2020) would be another banner year.

And who knows – with trillions in stimulus coming down the pike with zero percent rates – why not?

To be clear – I remain optimistic but I appreciate the headwinds.

For example, my immediate thought was valuations clearly don’t matter.  And perhaps we simply ignore earnings for the next two years?

I say that because there’s been no earnings growth…  all we seem to get is multiple expansion.

And hey – maybe 23x forward EPS is now the new normal in a negative real rate world?

Therefore, does the market deserve to trade at 23x forward earnings?

Maybe it does? 

But that’s essentially what Goldman are suggesting – perhaps even higher. Again, there could be weight to this given the fiscal and monetary environment.

As for the Santa Rally – it’s possible – but I think we will land somewhere within a 3% range of where we are today.

Regards,
Adrian Tout