Over the weekend, we were surprised to read that none other than recent market cheerleader Goldman Sachs had come up with six reasons why its chief equity strategist believes the market is poised for a material draw down (read “big drop”) in the coming weeks. Among these were the following:

  • Valuation is a necessary starting point of any drawdown risk analysis. At 16.7x the forward P/E multiple of the S&P 500 index ranks in the 86th percentile relative to the last 40 years. Most other metrics paint a similar picture of extended valuation. The median stock in the index trades at the 99th percentile of historical valuation on most metrics. The most likely future path of US equities involves a lower valuation.
  • Supply and demand trends also suggest downside risk. During the first quarter, the lack of investor positioning in domestic equities was the most bullish argument for a share price rally. Even as the S&P 500 index rebounded from its February 11 low, institutional and hedge fund US equity futures positions remained net short and our Sentiment Indicator hovered near 10 (out of 100, see page 5). A low sentiment reading represents a bullish trading signal for the subsequent 4-6 weeks. Sentiment has shifted sharply during the past few weeks. Since the end of March, investors have bought $23 billion worth of futures positions, lifting our Sentiment Indicator to 32, a less bullish level compared with mid-winter.
  • Corporate buybacks represent the single largest source of equity demand but may wane during coming months. Most firms completed 1Q earnings season by early May and have now resumed their discretionary buybacks, providing near-term support for the market. The month of May typically witnesses 10% of annual repurchase spending. However, spending normally decelerates in June and again in July, when just 7% of buybacks occurs as companies enter a blackout window ahead of 2Q earnings reports.
  • The fed funds futures market currently implies an 83% probability of zero (41%) or one (42%) rate hike in 2016. Our economists expect two hikes this year. The two upcoming FOMC meetings (June 14-15 and July 26-27) and the July Humphrey-Hawkins testimony to the House and Senate will offer opportunities for Chair Yellen to guide the market in the direction of the FOMC central tendency, which also anticipates two hikes in 2016. Put differently, given current futures market pricing we believe more likelihood exists for an incremental hawkish surprise than a dovish surprise.
  • Now-dormant economic growth concerns could awaken at any time and provide a catalyst for a sell-off. Official “total social financing” data shows China credit growth surged by $1 trillion in 1Q but acceleration in credit creation is needed to prevent a slowdown in activity by 3Q (see Asia Economics Analyst, May 3, 2016). Decelerating growth in China would cause investors to re-focus on the prospect of a US recession, a topic that has receded from client conversations after dominating discussions in 1Q. Our US-MAP index of economic data surprises has slipped back into negative territory and reinforces the risk of a slowdown (see page 20). The UK “Brexit” referendum on June 23 represents another imported economic risk.
  • The US presidential election is now part of every client conversation. The closeness of the race appears to be underpriced by the market given polls in prior presidential elections tightened as voting day approached. History shows that during a typical presidential election year, the S&P 500 index remains relatively range-bound until November (see Exhibit 4). But thus far 2016 has hardly followed a regular election playbook. The upcoming party conventions (Republicans on July 18-21 and Democrats on July 25-28) will almost assuredly raise political uncertainty and weigh on equity valuations.
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