Goldman Sachs: Comments on volatility (Kostin)(08/06/2024)
1. INDEX: At the aggregate index level, our target for the S&P 500 Index by the end of 2024 remains at 5600 (+8%).
Our forecast assumes that the US economy will continue to expand, that earnings will rise by 8% in 2024 and 6% in 2025, and that the index will trade at a P/E multiple of 20x, roughly in line with the current multiple. It should be noted that while the decline has been steep, it has hardly reached the magnitude of the market decline in a typical year (Chart 1).
2. HISTORY: Historical experience shows that investors typically make profits when they buy the S&P 500 index after a 5% sell-off.
Since 1980, an investor who had purchased the S&P 500 index at 5% below its recent high would have generated an average return of 6% over the following three months, enjoying a positive return in 84% of episodes (Chart 2).
Corrections of 10% (which would correspond to a level of 5100 on the S&P 500) have also been attractive buying opportunities in most cases, but with weaker outperformance success rates than after 5% declines.
It is worth noting that the future path of the S&P 500 following 10% corrections has been markedly different during resilient economic growth environments relative to pre-recession corrections.
3. ECONOMIC GROWTH: Cyclical stocks have underperformed, but the U.S. stock market does not appear to be pricing in a recession.
The recent rotation from Cyclicals to Defensives (ticker: GSPUCYDE) has been one of the steepest in recent history, with last Thursday’s move registering as the most extreme single-day rotation since March 2020.
However, cyclicals have been trading roughly in line with defensives since the end of Q1 2024, while at the same time overall economic data missed consensus estimates and pointed to a slowdown in the pace of real activity. Following the recent strong move, the cyclical vs. defensive pair now appears to reflect the actual pace of GDP growth of around 2-3% indicated by the Q2 GDP data and our economists’ Q3 GDP indicator (Chart 4).
Our economists forecast that US real GDP growth will average 2.7% in 2024 and 2.3% in 2025.
4. RATE CUTS: Historically, defensive sectors, including utilities, communication services and consumer staples, perform better when the Federal Reserve begins a cycle of interest rate cuts.
Following the release of the weak July jobs report, the market now expects the Fed to aggressively cut the funds rate over the remainder of 2024. Goldman Sachs Economics expects the Fed to cut rates by 25 basis points at each of its three remaining meetings in 2024 (September, November, and December). The S&P 500 typically rises when the Fed begins to cut, as long as the economy is not on the verge of a recession. Within the stock market, the beginning of Fed rate-cutting cycles is typically characterized by defensive sector outperformance, similar to the rotation that has occurred over the past week (Chart 5).
5. STRATEGY: Our basket of stable growth stocks represents an attractive investment strategy for investors concerned about a further slowdown in the US economy.
The sector-neutral basket is comprised of the 50 Russell 1000 stocks with the most stable EBITDA growth over the past 10 years. We measure growth stability as the standard deviation of year-over-year EBITDA growth on a quarterly basis. The proximate cause of the recent sell-off has been growth-related. The basket has returned 9% this year and has historically outperformed the S&P 500 during periods of slowing economic growth (Exhibit 6).
The average GSTHSTGR component trades at a 24% NTM price/earnings premium to the average S&P 500 stock (22x vs. 18x). However, this valuation premium is well below the peaks of over 50% reached during 2000 and 2020. Valuation has also not been a significant predictor of future returns for stable growth stocks.
Rising economic policy uncertainty would also be a tailwind for stable growth stocks. Investors' attention is likely to soon shift to the 2024 US presidential election, which is just three months away. Historically, stable growth stocks have outperformed when economic policy uncertainty increases.
6. BIG TECH: Large-cap tech stocks have fallen sharply, but their valuations continue to reflect optimism about AI despite investor concerns about the likely timing and magnitude of returns on their capital investments.
The P/E multiple of mega-cap tech stocks has declined 15% over the past two months (from 32x to 27x today), but remains above the 10-year median (24x) (Chart 9).
The stock has seen a 13% share price decline since July 10, compared to -1% for the S&P 494. While 5 of the 6 stocks have enjoyed positive revisions to consensus earnings estimates, a reversal in positioning and skepticism about the likely return on investment in AI have driven a contraction in valuation multiples.
Despite the decline, the group's current valuations remain above the 10-year median (24x), the 2022 average (26x) and the 2019 average (24x).
7. SMALL CAPS: The economic sensitivity of the Russell 2000 index will outweigh the impact of interest rate relief in the coming months.
Historically, economic growth has been the most important macroeconomic driver of small-cap profitability. However, since 2022, the Russell 2000 Index has been increasingly sensitive to interest rates and less sensitive to economic growth than in the past. This is because one-third of the companies in the Russell 2000 Index are unprofitable and about 30% of the debt in the Russell 2000 Index has a floating rate. From that perspective, falling interest rates should relieve pressure on small-cap balance sheets and reduce their cost of capital.
However, most of the recent decline in interest rates has been due to weakening economic growth expectations, which has weighed on cyclical stocks, including small-caps. The correlation between the Russell 2000 index and the nominal 10-year US Treasury bond yield has returned to positive territory, reflecting that once again “good news is good news”, similar to the pre-COVID regime (Chart 12).
