The recent market correction may have further to go, but a bear market is unlikely, Goldman Sachs strategists said in a Tuesday note.
The Wall Street firm points to several factors contributing to the correction, which began amid high valuations and elevated expectations for Q2 earnings. Specifically, investors have grown complacent, interpreting negative news as positive, relying on potential interest rate cuts and the robust earnings of large-cap AI companies to offset broader economic sluggishness.
The correction followed a prolonged period without a 5% drawdown, with global equities rising nearly a third from their October 2023 lows and the Nasdaq by about half. However, most of this rally has been driven by higher valuations rather than looser financial conditions, pointing to growing market complacency.
Several related factors have triggered the current market rout. Evidence of weaker growth momentum, particularly in Europe and China, has been building. The July US employment report, showing a rise in the unemployment rate to 4.3%, heightened fears that central banks, including the Fed, have been slow to cut interest rates. This shift in sentiment has led to a sharp underperformance of cyclical versus defensive stocks.
Moreover, a significant unwind of carry trades, exacerbated by a 10% rise in the Yen versus the Dollar and a collapse in Japanese stocks, has contributed to the market turmoil.
Elevated expectations for the second-quarter earnings season, particularly in large-cap US technology stocks, have also played a role. While overall results have not been bad, any disappointments have been heavily punished, reflecting concerns about the ability of leading tech stocks to achieve adequate returns on their AI investments.
Despite the correction, valuations remain elevated, particularly in the US. The S&P 500's current PE ratio is still above 20x, and the MSCI AC World's 12-month forward PE has only moderately compressed. Goldman Sachs strategists estimate that in a recessionary scenario, the S&P 500's PE could fall to around 18x, with a fair value of 4800.
“Furthermore, the concentration of the US equity market has only reduced slightly during the drawdown, suggesting that concentration risks remain heightened,” strategists added.
Goldman Sachs' Bull/Bear indicator, which comprises six fundamental factors, remains elevated, indicating heightened risks of a bear market.
“High valuation and rising US unemployment from a low level are two of the components that are most stretched, and suggest that we are not out of the woods yet,” Goldman’s team continued.
In the short term, strategists believe that the correction has further to go.
However, they believe that a bear market “remains unlikely,” as most bear markets result from recessionary fears.
“While our US economists have increased their probability of recession over the next 12 months by 10bp to 25%, it remains a risk rather than a likely outcome and yesterday’s ISM services print was strong suggesting that a broad downturn is not imminent,” they explained.
“At any rate, there is plenty of room for interest rates to fall to soften a continued bout of economic weakness and central banks are no longer constrained by the fear of high inflation.”
Moreover, significant cash reserves in money market funds are ready to capitalize on lower stock prices, while corporate and bank balance sheets remain robust, mitigating systemic risks. However, until valuations and risk appetite improve, strategists recommend a defensive approach.