Equity markets are overvalued by any measure and profit growth will need to catch up with stock price appreciation, says Goldman Sachs Chief Equity Strategies David Kostin.  In comments sure to rile market bulls, the Goldman Sachs US Weekly Kickstart Portfolio Strategy Research called the S&P 500 (INDEXSP:.INX) “slightly overvalued.”

S&P 500 valuation high from multiple perspectives: Goldman

“S&P 500 (INDEXSP:.INX) valuation is lofty by almost any measure, both for the aggregate market (15.9x) as well as the median stock (16.8x),” the report said. “We believe S&P 500 trades close to fair value and the forward path will depend on profit growth rather than P/E expansion. However, many clients argue that the P/E multiple will continue to rise in 2014 with 17x or 18x often cited, with some investors arguing for 20x. We explore valuation using various approaches. We conclude that further P/E expansion will be difficult to achieve. Of course, it is possible. It is just not probable based on history. We highlight 40 S&P 500 laggards and low valuation stocks to own in 1Q.”

Reflecting on investor expectations, the report notes with surprise that “many investors expect the forward P/E multiple to expand to 17x or 18x.” Noting that this assumption could be wrong, the report said: “For some reason, many market participants believe the P/E multiple has a long-term average of 15x and therefore expansion to 17-18x seems reasonable. But the common perception is wrong. The forward P/E ratio for the S&P 500 during the past 5-year, 10-year, and 35-year periods has averaged 13.2x, 14.1x, and 13.0x, respectively. At 15.9x, the current aggregate forward P/E multiple is high by historical standards. “

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Putting PE multiples into perspective, the report says “Most investors are surprised to learn that since 1976 the S&P 500 (INDEXSP:.INX) P/E multiple has only exceeded 17x during the 1997-2000 Tech Bubble and a brief four-month period in 2003-04 (see Exhibit 1).  Other than those two episodes, the US stock market has never traded at a P/E of 17x or above.”

Looking at historical averages to determine future probability, Mr. Kostin goes to the charts.  “A graph of the historical distribution of P/E ratios clearly highlights that outside of the Tech Bubble, the market has only rarely (5% of the time) traded at the current forward multiple of 16x (see Exhibit 2). The elevated market multiple is even more apparent when viewed on a median basis.  At 16.8x, the current multiple is at the high end of its historical distribution (see Exhibit 3).”

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Relationship between stocks and interest rates: Goldman

Looking at the relationship between stocks and interest rates, the report noted “the earnings yield gap between the S&P 500 (INDEXSP:.INX) and ten-year Treasury yields  currently equals about 325 (basis points) bp. Goldman Sachs Economics forecasts bond yields will creep higher to 3.25% by year-end 2014, a rise of just 25 bp. If the earnings yield gap remains unchanged, then the ‘fair value’ multiple according to the Fed model would be 15.2x at year-end 2014. The implied index level would be 1900 assuming our 2015 EPS forecast of $125. However, bond yields could rise by more than we expect and hit 3.75% while the yield gap could narrow to perhaps 275 bp. The resulting EPS yield of 6.5% represents a forward P/E of 15.4x implying a S&P 500 level of 1923. Exhibit 4 of the Dec 6th Kickstart shows valuation using various yields and yield gaps.”

After considering interest rates, the report starts to draw key conclusions.  “Incorporating inflation into our valuation analysis suggests S&P 500 is slightly overvalued,” the report said.  Looking forward, we believe further P/E expansion will be difficult to achieve. Of course it is possible. It is just not probable based on history based on the high level of multiples, significant 50% expansion that has already taken place over the past two years, and rising bond yields. Margins stand at an all-time high, making the P/E multiple even more elevated from a risk perspective. Our view that the S&P 500 has a 67% probability of a 10% drawdown during 2014.”