- The stock market remains too expensive even after its 25% year-to-date decline, according to Goldman Sachs.
- The S&P 500’s forward P/E multiple of 15.8x is in the 66th percentile on a historical basis, and earnings estimates could still be too high.
- There are bargains to be had in US small caps and value stocks, Goldman’s David Kostin said.
Even a 25% decline in the stock market is not enough to bring valuations down to attractive levels, Goldman Sachs’ David Kostin said in a Friday note.
The S&P 500 has made good progress during this year’s downward trend on denting valuations, with the forward price-to-earnings ratio falling to 15.8x today from 21x at the start of the year. Still, a forward P/E multiple of 15.8x falls in the 66th percentile on a historical basis, according to the note.
“On top of this, many investors are skeptical about the EPS forecasts that underlie that metric,” Kostin said. That means if earnings results fall short of estimates, the current valuation of the S&P 500 could be even higher than stated in its forward P/E multiple.
US stocks are also expensive when compared to interest rates, which have surged amid an aggressive rate hike cycle from the Fed this year. The 10-year US Treasury yield closed above 4% on Friday for the first time since 2008, and the 3-month Treasury Bill yield has soared from under 10 basis points at the start of the year to 3.73% today.
“Despite elevated recession risk, geopolitical tension, and a generally murky macro outlook, the earnings yield gap – a common proxy for the equity risk premium – trades close to the tightest levels in 15 years,” Kostin said.
“With the S&P 500 trading 2% above our base-case year-end target of 3,600 and 17% above our hard-landing scenario downside target of 3,150, the risk/reward for owning the broad US equity index is unattractive,” Kostin said.
But a 25% sell-off in the stock market means there are bargains to be had in certain sectors, even if valuations remain above historical averages. According to Kostin, investors should be looking at small caps and value stocks.
“Value and short duration stocks look attractive relative to long duration and growth stocks… Provided that interest rates remain elevated, we expect long duration stocks will continue to face stronger valuation and performance headwinds than their short duration peers,” Kostin said.
The current environment is ripe for continued outperformance of value stocks relative to growth stocks because historically, value has performed well around the start of economic recessions, during months after CPI peaks, and after the Fed’s last rate hike during a tightening cycle, Kostin highlighted.
Meanwhile, small cap stocks trade at much more attractive valuation levels than large-caps, according to the note. The S&P SmallCap 600 trades at a P/E multiple of 11x, which is near its cheapest level of the last 30 years. “This multiple also represents a 30% discount to the S&P 500,” Kostin said. That’s the largest discount since the dot-com bubble, and if earnings don’t deteriorate meaningfully from here, it could represent a big opportunity for investors.
