GOLDMAN: Get ready for another stock market dive

It’s been a shaky year so far for the stock market. A huge drop to start the year was followed by a monumental comeback and now the market appears to have settled into a relatively stable, albeit uninspiring range.

A market sell-off between 5% and 10% should be coming soon, according to Goldman Sachs US Equity Strategist David Kostin. A mix of factors currently building up in the market, along with the market’s recent history of pullbacks, should end up with a drop in the next three months.

“Although investors appear complacent in the wake of Brexit, a maturing economic cycle with elevated valuations, decelerating buybacks, and growing political uncertainty provide the basis for potential market weakness in the second half,” wrote Kostin.

There’s a lot of breakdown there but here’s a quick refresher of Kostin’s concerns:

  • Valuations for stocks are well-above their long-run averages, making them expensive. The twelve month forward price-to-earnings of the S&P 500 is 16.4x, whereas the average over the past 10 years is 14.3x. This increased valutaion even drew the attention of the Federal Reserve.
  • Buybacks have been a massive source of support for stocks, in fact the only net source of demand. For instance, Bank of America Lynch said their corporate clients have bought back $20.6 million in stock on net, while retail investors, hedge funds, and intitutional investors have sold $38.1 million stocks on net. Tightening credit conditions and decreasing cash flows may dry up this source of support.
  • Everyone is not only worried about Brexit, but also a myriad of future political events that are sowing the seeds of market uncertainty.

In addition to current trends, Kostin pointed to the historical falls in the stock market since the end of the financial crisis. Even in the past 12 months there have been significant drawdowns, in both August of last year and the start of 2016. This pattern lead Kostin to gauge the severity of the drop.

“Most recent drawdowns have troughed at a forward P/E of roughly 15x,” wrote Kostin.

“Given consensus bottom-up next-12-month EPS of $123, this same multiple would value the S&P 500 at roughly 1850, or 13% below its recent high of 2115 reached in early June. In 16 S&P 500 pullbacks of 5% or more since 2009, the S&P 500 has declined by a median of 7%, which would bring the S&P 500 to roughly 1950.”

There is some good news here, however, said Kostin. While the sell-off will come in the next three months, Kostin expects some recovery in the market that will bring the S&P 5oo back to 2,100 by the end of the year. As of the market open on Wednesday, the index was trading at roughly 2,084.

There are a few reasons to expect the support, according to the Goldman strategist.

“At the same time, above-trend US economic growth, a return to positive but slow earnings growth, a cautious Fed, and the lack of investment alternatives around the globe will support equity prices without providing a catalyst for further upside,” said the note.

So get ready for the fall, but also the bounce back.

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