Over the past year, Robert Shiller has proclaimed that stock-market valuations are at “unusual highs,” that low volatility makes him “lie awake worrying,” that equities look “dangerous,” that passive investing has created “a chaotic system,” and that today's markets remind him of 1929. This is all of a piece with his behavioral-econ approach to finance – outlined in his Greenspan-referencing Irrational Exuberance – which posits that markets aren't the finely tuned rational-expectations machines imagined by Eugene Fama et al but rather a seething mass of delusion and spectacle prone to gross imbalances and wild swings. Accurate or not, it makes for good TV.
Anyway, Goldman's equity team must have something against Shiller and/or his scholarship, because their 2018 equity outlook just dropped and it appears to be carefully worded to give the guy an ulcer. “The bull market will continue in 2018,” they write. It continues:
Our “rational exuberance” rests on a combination of above-trend US and global economic growth, low albeit slowly rising interest rates, and profit growth aided by corporate tax reform likely to be adopted by early next year. Assuming tax reform passes, we forecast 2018 S&P 500 EPS will jump by 14% to $150 and the index will advance by 11% to 2850 at year-end 2018. If tax reform fails, S&P 500 will fall near-term by 5% to 2450.
To dispel the notion that their call isn't just a more self-aware (or dare we say ironic) version of irrational exuberance, Goldman presents this chart, comparing their call to the three years following Alan Greenspan's famous “irrational exuberance” speech:
To the little Shiller in your head screaming about the CAPE ratios and stretched valuations, Goldman has this to say:
The current equity market valuation is certainly stretched in historical terms but it does not appear unreasonable based on the high level of corporate profitability. The return on equity (ROE) of the S&P 500 equals 15.4%, which typically corresponds with a price/book multiple of roughly 3x. The index currently trades at a modest premium of 3.3x.
So we've got secularly higher profit margins, improving GDP, and perhaps some higher energy prices and a little tax reform cherry to top it off, all of which makes sticking it out in stocks perfectly rational, if slightly exuberant. The challenge, of course, is knowing when that exuberance turns to the dark side. Here's Goldman's take:
We would deem it “irrational exuberance” if the S&P 500 during the next three years followed the exponential trajectory of stocks in the late 1990s. In that situation, the S&P 500 would trade at 5300 by year-end 2020 (a 105% rise from today). If stocks instead trade at a similar forward P/E to the Tech Bubble (24x), it would imply a year-end 2020 index level of 4050 (57% above today).
The case for rational exuberance seems solid enough, but this part seems like a bit of a cop-out. It is indeed convenient that we have within the last two decades a rally so madly ebullient that we can use it as a cautionary tale anytime we have the occasion. But that can't be your only red flag. The dot-com boom was anomalous in the extreme; we're not likely to see equities repeat that pattern again absent another technological paradigm shift on the order of the internet revolution.
But markets can still veer into zaniness even if they don't reach late-90s extremes. It's just a really low bar to satisfy. Saying you're only going to become concerned once the market hits dot-com levels is akin to saying the nuclear reactor is safe until it starts giving off Chernobyl vibes.