David Kostin, Chief U.S. Equity Strategist at Goldman Sachs Group Inc (NYSE:GS) estimates that the S&P 500 (INDEXSP:.INX) will reach 1,900 in 2014. So far in 2013, his trade of choosing U.S. stocks versus U.S. Treasuries has been a winner. The S&P 500 has returned about 28% year to date as of December 4, 2013 while Morningstar Long US Government Bond has lost 8.2% in the same period.
Choose stocks over bonds
Economic acceleration in the U.S. relative to 2012 supports further equity gains. Goldman Sachs Group Inc (NYSE:GS) economists estimate that U.S. GDP growth will be 1.6% in 2013 and 2.8% in 2014. This output will likely support low inflation and U.S. 10 year Treasury rates will continue to rise. Operating earnings per share (EPS) will probably improve in the next three years, increasing by 11%, 8%, and 7% in 2013, 2014, and 2015 respectively. On the supply side, share buybacks could support equity prices as Goldman Sachs forecasts $450 billion of buybacks for the next year.
S&P earnings yield and U.S. Treasury rates show gap
The current S&P 500 (INDEXSP:.INX) earnings yield is 5.07% while the current U.S. 10 year Treasury rate is at 2.84%. The gap between the two yields is 2.23%. What this suggests, in Goldman Sach’s view, is that Treasury rates could continue to rise without hampering a rise in equities. However, as the gap closes, equity valuations may become less attractive.
Valuation dispersion is low relative to history
The next 12 month P/E standard deviation as a percentage of mean (dispersion) for the S&P 500 is at a 23-year low at 35%. This could suggest that more volatility is possible as market participants account for both an improving economy and possible U.S. Federal Reserve bank tapering. Regarding sectors, all of the dispersions are below 30-year averages mirroring the S&P 500’s dispersion. According to Goldman Sachs Group Inc (NYSE:GS), industrials and financials have the greatest potential for gains in an accelerating economic growth environment while defensive sectors such as consumer staples and healthcare tend to lag more cyclical names.
Source: Goldman Sachs Research