the start of a tightening cycle and the Federal Reserve is expected to start raising rates on the third quarter of 2015. Stocks gained before the Fed did its first rate increase in 1994, 1999 and 2004. Policymakers met on Jackson Hole on August 21st through August 23rd and debated on timing of rate increases. Fed Chairwoman Janet Yellen indicated that if labor conditions continue to improve or if inflation starts rising rapidly, Fed rate hikes could start sooner than markets anticipate. However, she conceded that labor statistics such as the unemployment rate may be overstating labor market strength.

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Stocks gained before rate hikes

Goldman Sachs Economic Current Activity indicator suggests that U.S. GDP could grow at 3.5% annually. Non-farm jobs have increased at a faster pace. Year to date, non-farm jobs have increased at an average clip of 230,000 per month. In 2013 and 2012, the monthly non-farm job growth was 194,000 and 186,000, respectively. ISM manufacturing and non-manufacturing indices have risen to levels not seen in at least 3 years.

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Goldman forecasts S&P 500 to gain 16% through 2018

Goldman Sachs economics team expects the Federal Reserve to end the tightening cycle when the Fed funds rate reaches 4%. In the team’s view, such level is what the central bank considers neutral to maintain full employment and 2% inflation. Goldman’s economics team recognizes views from other market participants who believe the economy is “experiencing secular stagflation” and that rates will remain lower than 4% indefinitely. In that scenario, Goldman thinks that the Fed funds rate could remain at 2%.

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Within Goldman’s Fed funds rate base scenario, Kostin forecasts the S&P 500 to reach 2,300 in 2018. This represents a 16% increase from current levels. Treasury, GDP and equity risk premiums will likely adjust to neutral levels as well. Goldman forecasts the 10 year Treasury to be at 4.5%, GDP growth to average between 2%-2.5% and an equity risk premium of 3.3%. Such level is close to the average equity risk premium of 3.5% recorded since 1981. Goldman’s S&P 500 estimate is sensitive to both Fed Funds rate and GDP growth rates deviating from the neutral forecast estimates. A 50 basis point shift in the neutral Fed Funds rate could change the S&P 500 estimate by 9%. Similarly, a 50 basis point change in economic growth drives a 10% shift in S&P 500 estimate.

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Goldman’s sector neutral stock basket to benefit from market gains

Goldman’s dual beta stock basket (Bloomberg ticker: GSTHBETA) contains 50 stocks with the highest exposure to changes in the U.S. economy and the S&P 500. The basket outperformed the S&P 500 by 3.5% through June 2014 but underperformed through July. On a monthly basis in August, the basket is outperforming the S&P 500 by 25 basis points. Kostin and his team expect this basket to profit the most from gains in U.S. stocks and from economic acceleration. Sectors within the basket with the highest betas include consumer discretionary, materials, industrials and financials.

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