Goldman Sachs’s Weekly Kickstarter published on Friday, October 3rd highlights that the trend of weak balance sheet stock outperformance over the last two years will end as financial conditions tighten. That’s because tightening financial conditions typically spells trouble for companies with high leverage and/or weak balance sheets.

Strong Balance Sheet Stocks

Weak Balance Sheet Stocks

GS analysts David J. Kostin and colleagues argue that the era of the weak balance sheet stock is rapidly coming to a close, and that strong balance sheet stocks are likely to begin to move forward ahead of the Fed actually making the first rate hike in mid-to late 2015.

The newsletter notes that Goldman Sachs continues to predict a 10% rise in the S&P 500 index over the next year.

Strong Balance Sheet Stocks

S&P 500 earnings projections

Kostin et al. point to their top-down S&P 500 EPS forecasts of $116 and $125 for 2014 and 2014, and note that both estimates are based on 8% growth. Moreover, their bottom-up consensus projects a solid 9% increase in 2014 to $117, and another 12% move up in 2015 to $131.

Strong Balance Sheet Stocks

Weak China and Eurozone, but strong U.S. economic growth

The GS report does note that growth in both the Eurozone and China is lagging, with Goldman projecting 1% GDP growth in the Eurozone and 7.1% GDP growth in China. The analysts also highlighted that a number of U.S. fund managers expressed “serious concern that decelerating Europe and China growth will spill over to the U.S.”

The U.S. economy is, however, clearly picking up steam. Last week’s 248,000 job gain and unemployment rate dropping to 5.9% are yet more evidence the tide has turned. Moreover, both the ISM manufacturing and non-manufacturing indices look strong at 56.6 and 58.6, respectively. Kostin and colleagues note that GS has recently upped its third quarter GDP estimate to 3.2%. They also highlight the firm’s third quarter estimate for year/year EPS growth of 7%, which dovetails well with their full-year EPS target of $116.

Strong balance sheet stocks outperforming since July

Strong Balance Sheet Stocks

Last but not least, the GS analysts say the worm has actually already begun to turn. They note that weak balance sheet stocks have underperformed strong balance sheet stocks by 380 bp since mid-July, around when  FCI’s tightening began. This turnaround marked the end of a 48% better performance of weak vs. strong balance sheet stocks over the previous two years (93% vs. 45%, respectively, relative to 52% for S&P 500).

Strong Balance Sheet Stocks

Strong Balance Sheet Stocks