S&P 500 (INDEXSP:.INX) return on equity for 1Q2014 dropped modestly to 16.2% from 16.3%, thanks to lower leverage and higher taxes offsetting improvement in margins and assets/asset turnover, points out a recent Goldman Sachs report.

Stuart Kaiser and team at Goldman Sachs in their report dated June 30, 2014, and titled: ”US Thematic Views” highlights that ROE dropped in seven of ten S&P 500 (INDEXSP:.INX) sectors in the first quarter of 2014.

Modest drop but remains historically high

The Goldman Sachs analysts note despite ROE dropping modestly to 16.2% in the first quarter, ROE remains higher than last year and above two-thirds of quarters since 1975. The following graph elucidates this trend:

S&P 500 ROE remains historically high

The analysts point out that a similar trend was also witnessed on an ex-Financials basis, where ROE eased to 19% and in its 86th percentile since 1975.

The analysts highlight that their market outlook continues to indicate that any further ROE gains will be driven by increases in either leverage or sales turnover, as EBIT margins are very high historically and both tax rates and borrow costs are quite low.

The Goldman Sachs analysts note S&P 500 (INDEXSP:.INX) EBIT margins rose back above 15.1% and added an estimated 5 bp to ROE. The following graph highlights that EBIT margins have recovered after a modest swoon:

Recovery in EBIT margins

They point out that such a margin level is its highest since 1Q 2008 and was aided by increased margins in Info Tech, Telecom Services and Financials.

ROE dropped in seven of ten S&P 500 sectors

Stuart Kaiser and team at Goldman Sachs point out ROE dropped in seven of ten S&P 500 (INDEXSP:.INX) sectors in the first quarter of 2014, with large and higher ROE sectors such as Industrials, Info Tech, and Consumer Staples witnessing the biggest declines. For instance, Information Technology ROE dropped by 37 bp to 21.6% in 1Q 2014 thanks primarily to higher effective taxes and lower sales/asset turnover. The following table captures the trend:

Industry contribution

The analysts note the Industrials sector had the largest ROE decline among S&P 500 (INDEXSP:.INX) sectors. Moreover, leverage in the sector has declined in 14 of the last 18 quarters and was especially negative this quarter, driving ROE down 50 bp. The following graph illustrates the continuous decline in Industrials leverage:

Decline in Industrials leverage

Alluding to their research, the analysts point out ROE, lagging between four and eight quarters, offers the best fit to historical S&P 500 returns. The analysts also highlight that the historical relationship between ROE and price/book ratio indicates that investors typically reward superior profitability with higher valuation.

The Goldman Sachs analysts note that in the first quarter, S&P 500 (INDEXSP:.INX) ROE dropped to 16.2%, and the book value reached $688, indicating a current price/book value of 2.75x. The analysts point out that the current relationship between profitability and valuation is consistent with history where ROE in the 16% to 17% range has been associated with P/B ratios in the 2.5x to 3.0 range. The following graph captures the relationship between ROE and PB:

ROE Vs PB relationship