The S&P 500 (^GSPC) briefly traded above its all-time closing high on Friday following the stronger-than-expected US jobs report. It was just the latest highlight in this extraordinary bull market that started back in March 2009.
Wall Street’s stock market experts are a bit divided on what will happen next, especially with the recent surprise Brexit Leave vote hanging over everyone’s heads. The bulls have their reasons why stocks will go higher and the bears have their reasons for why we may be topping out.
FundStrat Global Advisors’ Tom Lee is one of the more bullish strategists out there. But even he knows that a continued rally in the market is no sure thing.
“What could go wrong?” Lee said in a recent note to clients. “There are many issues potentially becoming so significant that the economy and markets succumb to the risks.”
In a note to clients, Lee identified seven risks (verbatim):
- Brexit becomes EU contagion: Clearly greatest concern for investors at the moment.
- Policy uncertainty: A broader issue for markets is the inability to track policy risk which has grown in frequency in past few years.
- China: China is navigating an extremely challenging balance of slowing credit growth/expansion while transitioning growth from an investment-oriented to consumption oriented model. The structural changes over the past decade have resulted in China and its EM neighbors increasingly operating as an ecosystem, with the US less affected by “shocks” in China.
- Commodity producers: Commodity producers are seeing increasing financial stress, stemming from falling volumes and prices, currency weakening and diminished confidence by capital markets.
- Deflation: Falling inflation and the pernicious effects of deflation weigh on markets– particularly since debt burdens become very difficult to manage in a falling pricing environment.
- Credit cycle: Default expectations have risen in 2016, stemming concerns about falling commodity prices and reduced market liquidity. Investors have pulled nearly $80 billion from high-yield mutual funds over the past 18 months.
- Central bank policy divergence: Lastly, investors worry about policy errors from Central Banks. The Fed might resume tightening while other major countries are easing. Hence, the fear of a continued surge in USD and therefore more headwinds to US corporates.
Some of Lee’s peers aren’t waiting for these risks to become reality. In a chilling research note on Wednesday, Goldman Sachs’ David Kostin warned clients that the S&P 500 could plunge to 13% to 1,850 before rallying again.
“The fallout from Brexit is just one of several headwinds to US equity returns in the next few months,” Kostin said. “Other risks include the upcoming US presidential election, unstable growth and policy in China, and a deceleration in corporate buybacks, which represent the largest source of demand for US equities.”
The bad news could start coming in the next few weeks.
Earnings season kicks off this week, which means the managements of big companies will announce Q2 financial results and, importantly, offer outlooks. Analysts agree that Q2 earnings likely declined, and most believe that earnings growth will accelerate at a double-digit pace. But there are also skeptics who believe managements’ tones will be more bleak than what’s expected.
“Given the growth and data backdrop, expectations appear far too high,” Barclays’ Keith Parker said on Thursday. “Downgrades to H2 and 2017 are likely to be a headwind, with negative corporate guidance an added risk as investors assess the fallout after the Leave vote.”
“Don’t believe the hype: 2017 earnings growth likely to be closer to 5% and not 14%,” JPMorgan’s Dubravko Lakos-Bujas said in a recent note to clients. “For those placing faith in the grossly enthusiastic consensus EPS growth assumptions in the coming years, these hockey-stick projections will likely be revised down sharply. Over the last ten years, the consensus growth estimate for the following year was typically revised down by ~5%. Since consensus 2017 EPS growth of 14% is based on unrealistic assumptions of +7% sales growth (+5% ex-energy) and +50bp margin expansion, we expect an even sharper revision to next year’s EPS estimate (in the range of ~$10). We would expect a more realistic ~$125 EPS for 2017. However, this will also depend on USD trajectory and the degree of indirect impact from Brexit and US Election on business activity.”
It’ll be a couple of months before we know whether or not Parker and Lakos-Bujas are right to be so skeptical.
In the near-term, Q2 earnings themselves could prove to be a source of bullishness.
“Earnings remain the key ingredient for stock price direction and there are several reasons to be optimistic,” Citi’s Tobias Levkovich said on Friday. “Energy prices have rebounded and the dollar’s drag will be meaningfully lessened in the months ahead compared with the prior six quarters. Industrial production is set to rise given five months of improving ISM manufacturing new orders, which also supports a better EPS backdrop.”
Levkovich agrees with the bears that the tone of management this quarter is likely to be very cautious. But he warns against blowing warnings out of proportion.
“While Brexit excuses could be used by some management teams for lowering earnings guidance in the next two weeks, most companies simply do not have the kind of European or UK sales exposure to derail outlooks,” he said.
Sam Ro is managing editor at Yahoo Finance.