Flat is the New Up

Episode Summary

Executive Summary: Goldman Sachs strategist David Kostin says slower U.S. growth, a China slowdown, and collapsing oil prices have forced a downgrade to 2015 S&P 500 earnings and a lower year-end target, while 2016 should see a partial profit rebound. He expects a muted equity market ahead, favoring domestic-facing companies, shareholder returns, and high-quality stocks amid weak earnings, a likely Fed hike, and elevated uncertainty.

Main Topics: Lowered S&P 500 earnings outlook (Priority: 5/5): Kostin explains that weaker U.S. GDP growth, China’s slowdown, and low oil prices led Goldman to cut S&P 500 profit forecasts and the index target for year-end 2015. Oil’s impact on profits and capex (Priority: 5/5): He argues that the energy sector’s collapse is the main driver of earnings weakness and will also reduce capital spending across corporate America, affecting industrials and materials. 2016 market outlook and valuation (Priority: 5/5): Despite weak 2015 earnings, he expects profits to recover in 2016 and the S&P 500 to rise modestly, but with valuations already high and returns likely to be muted. Investment positioning in a slow-growth market (Priority: 4/5): Kostin recommends domestic revenue exposure, shareholder returns via dividends/buybacks, and high-quality stocks as the best strategies in a flat-to-muted market environment. China slowdown and investor confidence (Priority: 4/5): Although S&P 500 exposure to China is small, he says China weakness matters because it hurts investor confidence, raises doubts about decoupling, and creates concern for exporters. Fed tightening and multiple compression (Priority: 4/5): He expects a December Fed hike and argues that the start of a tightening cycle typically compresses valuation multiples even if earnings continue to grow. Buybacks, M&A, and capital allocation (Priority: 3/5): With capex needs limited and cash balances high, companies are likely to increase buybacks and M&A, especially tuck-in acquisitions of private companies.

Key Arguments: 2015 S&P 500 earnings were cut because U.S. growth slowed, China weakened, and oil prices fell sharply; energy earnings are the biggest driver of the downgrade. The energy sector’s contribution to S&P 500 profits drops dramatically, from $13 per share last year to about $2 this year. Kostin expects a rebound in 2016 earnings to about $120, implying roughly 10% growth and a modest S&P 500 gain to around 2,100. Investors should expect a flat or near-flat market over the next several years because the post-2009 equity rally is unlikely to repeat. Lower oil prices help consumers in theory, but the market impact is negative in the short run because energy profits and energy-linked capex fall. Domestic-facing companies should outperform because U.S. end demand is stronger than in Europe or Japan and a stronger dollar hurts exporters. Companies returning cash through dividends and buybacks should outperform because capex opportunities are limited and buybacks are rising. China matters less through direct revenue exposure than through confidence effects and concerns about global growth. A Fed hike is likely to reduce valuation multiples even if the economy and earnings continue to expand. Market uncertainty is elevated, defensive stocks are expensive, and investors are favoring quality, liquidity, and larger-cap balance sheets.

Data Points: S&P 500 quarterly return: -7% - Largest quarterly decline since Q3 2011, describing the market’s rough third quarter in 2015. 2015 S&P 500 earnings forecast: $109 - Goldman’s revised profit forecast for year-end 2015, down $5 from prior estimate. Forecast change: -$5 - Reduction in expected S&P 500 earnings versus the prior forecast. 2015 earnings growth: -3% year over year - Kostin says $109 implies the first annual earnings decline since 2009. Last year S&P 500 profits: $113 - Used as the baseline for explaining the energy-sector drag on profits. Energy earnings last year: $13 - Portion of last year’s S&P 500 profits contributed by energy companies. Energy earnings this year: $2 - Expected energy contribution to S&P 500 earnings in 2015. 2016 S&P 500 earnings forecast: About $120 - Expected profit rebound next year. Expected 2016 earnings growth: Almost 10% - Projected increase in S&P 500 earnings in 2016. S&P 500 year-end target: Around 2,100 - Kostin’s forecast for the index by end-2016, up from about 2,000 at end-2015. Current S&P 500 level referenced: Around 2,000 - Approximate end-of-2015 level used in the discussion. U.S. GDP growth: Close to 2.5% - Kostin’s estimate of U.S. real growth supporting domestic-facing companies. Capital spending share from energy companies: About 1 out of every 3 dollars - Share of S&P 500 capex tied to energy-sector spending. Corporate cash available: $2.1 trillion - Amount of cash companies are expected to deploy in the year. Planned buyback increase: Close to 20% - Expected rise in share repurchases. Capacity utilization: About 80% - Used to argue incremental capex needs are limited across many industries. Long-term capacity utilization average: 40-year average - Reference point for current utilization levels. Corporate margins: About 9% - Described as record-high, supporting cash generation and buybacks. Buyback seasonality: 25% of annual buybacks in November and December - Explains why year-end repurchases could support markets. Defensive stocks valuation: Around 17.5x forward earnings - Shows investors’ defensive tilt and high pricing for defensive names. Cyclical stocks valuation: Around 14.5x forward earnings - Contrasts with defensives and reflects caution on growth-sensitive sectors. S&P 500 price-to-book: Around 2.8x - One of several valuation measures indicating the market is rich.

Pivotal Quotes: "Flat is the new up." — David Kostin: His central message on expected U.S. equity market returns over the next several years. "At the high end of a range of fair value." — David Kostin: His characterization of current U.S. equity valuations across multiple metrics. "The S&P 500 is trading at very high valuation levels." — David Kostin: His explanation for why future gains may be muted as earnings rise but multiples compress.

Implications: Investors should prepare for modest returns, favor domestically oriented, quality balance-sheet names, and expect buybacks/M&A to stay important. Weak earnings and a Fed hike could cap gains even if the U.S. economy avoids recession.