US equities have staged a remarkable rally in the first half of this year, but is the bull market still on from footing?
And how optimistic should investors be now?
If I think about the series of earnings reports that we'll get in the second half of this year, there'll be a lot of focus on what is the potential revenue gains and earnings contributions coming from all this investment that's being made in AI.
There's a lot of questions around that.
I'm Allison Nathan and this is Goldman Sachs' exchanges.
Today I'm sitting down with my colleague in Goldman Sachs' research, David Costin, chief US equity strategist.
David recently boosted his S&P 500 year-end target from 5200 up to 5600.
We'll talk about what's changed, what investors should focus on now, and what the rest of the year could bring.
David, it is great to have you back on the program.
Allison, thanks for inviting me.
David, when you made your recent upgrade, you made the very interesting observation that five stocks have been responsible for 60% of the rally year to date.
There's so much focus on market concentrations today.
Is that concentration concerning to you at all?
I think the best way to frame the return for the US equity market this year is to keep two numbers in mind.
The first is at the S&P 500 index, which is a capitalization weighted index, has risen by 15% year to date.
In comparison, the typical stock has risen 5%.
And that difference is really over a flexion of the point you made that five leading stocks, mostly associated with artificial intelligence, they have driven the market capitalization index of 15%.
So those companies include Nvidia, Amazon, Microsoft, Google, also knows alphabet, and Meta.
They're the companies that are making significant investments in their CAPEX and R&D that is totally now around 22% of all CAPEX and R&D dollars.
Research and development dollars spent in the country are by these companies in pursuit of the AI dream.
And these five companies are driving the market performance.
That's correct. Now, the fundamentals actually support this.
Those five companies have increased their earnings in the first quarter by 84% versus the prior year.
In comparison, the rest of the market had about 5% increase in earnings.
And so fundamentally, it has been better earnings have helped drive these share prices higher.
That's the actual results for the first quarter.
If you think about the earnings revisions that analysts have made for these companies as well, they've increased their estimates by 38% in comparison with a 5% reduction in earnings estimates for the rest of the market.
And so fundamentally, it's been better earnings, better expected earnings, which have lifted these stocks and therefore had the whole index level rise by 15% this year.
So it's not hype. It's real fundamentals, but I have to ask then about really one of the key drivers, which has been in video off of the AI theme and very recently we've seen some underperformance in that stock.
I'm not asking you to talk about the stock, but does that make you nervous?
So even if it is real performance leading to real returns, that these stocks can be vulnerable and have a big impact on the market.
It's an enormous question.
And there's been a swift pivot that's taken place in the last several weeks from portfolio managers.
Profile managers had been really embracing the euphoria, the excitement about AI and what that might mean for corporate profitability, for business activity, productivity and the economy.
And more recently that has shifted and there's much more questioning of management's whether or not they can actually deliver better financial results as a consequence of all this investment that's taken place.
I think there's a serious issues that need to be addressed and that will probably come to four in the next six to 12 months.
If I think about the series of earnings reports that we'll get in the second half of this year for the second quarter results and the third and the fourth quarter for early part of next year when those results are released, there'll be a lot of focus on what is the potential revenue gains and earnings contributions coming from all this investment that's being made
in AI. There's a lot of questions around that.
In fact, you've just wrote the report on the GNI, too much spend, too little benefit.
I think that is really where investors are right now, as compared with as recently as a month ago.
And the bar's got to be pretty high right now, too, right?
Because ultimately, even if the earnings have matched the performance or driven the performance, valuations are high.
So does the valuation question concern you at all?
The valuation question is a concern, the overall index for the S&P 500 trades around 21 times forward earnings, which is high.
It's around the 91st percentile versus history.
So it's certainly high in a historic basis.
On the other hand, the margins for US corporates are extremely high.
And the interest rate environment relative to history is actually relatively somewhat lower than average.
In this environment, our model suggests that the market multiples likely to be slightly lower than it is now, maybe closer to 20 and a half times by the end of this year.
So a slight multiple compression is part of our assumptions in our forecast for the S&P 500 data this year.
And how much does the interest rate environment factor into that?
Because of course, the other big driver of markets and focus of markets this year has been the Fed.
And the fact that expectations for rate cuts have continued to be pushed later.
How much impact does that have on how you think about the market?
I think about it in two ways.
The first is from a fundamental valuation perspective.
It's actually longer term US interest rates.
Think about the treasury yield 10 year US treasury yields around four and a quarter percent right now.
Real yields, real tenure bond yields adjusting for inflation around 2%.
That is a more important determinant of the multiple of the stock market.
Another hand, the Fed cutting rates, which is the expectation for both the market and our own economists will have a particularly significant impact on smaller cap stocks.
Because smaller cap stocks, about 30% of their borrowings are in a floating rate form.
And therefore lower interest rates at the short end of the yield curve will reduce their interest expense, leading some analysts to be raising their earnings estimates for these companies and higher earnings positive earnings revisions.
Typically is associated with stock prices rising.
So smaller cap companies will be the best, most proximate beneficiaries of an easing Fed policy.
In contrast, the rest of the market, the broader market is more linked valuation wise to the longer end of the curve.
Understood. Okay, so we put this all together.
We have this tremendous performance in tech stocks, but there's a lot of concentration today.
We have the cuts not coming as soon as we expected, but you've recently raised your forecast for the S&P 500.
So walk us through what led you to make that forecast change.
House and there's basically two reasons why we've raised our forecast.
Previously, it was 5,200.
Currently, we expect the S&P 500 to close this year at around 5,600.
It's a very modest 2% gain from where we are today.
So slight increase in the opportunity set for returns of the market.
There are two building blocks.
One is valuation. The other would be earnings.
The typical pattern of earnings revisions for consensus estimates for the analysts.
And the market does price consensus rather than our forecast.
The consensus expectations typically fall by 8%.
Analyst estimates are cut by 8% over the investment horizon.
The pattern this year has actually been no reduction in aggregate level of earnings.
As I said earlier, you had a 38% increase in the expectation of the earnings for these five leading AI beneficiary companies.
And the rest of the market has seen a 5% decline.
But as a result, we're not anticipating very much of a decline in the consensus expectations.
That's sort of one aspect, a less than average negative revisions pattern.
The second would be in our valuation models that the fair value of the market would be slightly higher than we had previously assumed.
And now it's slightly to be in the vicinity of 20 and a half times.
Previously, it had been closer to 19 and a half times.
So a slight increase in fair value for the multiple and a slightly smaller decline in the consensus expectations.
So if I'm hearing correctly, the market is more optimistic than you expected it to be or what the historical pattern has suggested it would be.
But is the market too optimistic?
Is the market too optimistic?
My response would be it's fairly valued.
And the trajectory of the market going forward will pretty much be in line with the trajectory of earnings.
And earnings are growing modestly as we look into 2025.
And portfolio managers are already focusing on next year's earnings.
Like it would be rising by around 6%.
So our expectation is the trajectory of the market looking out, you know, years time would be rising somewhat in that direction.
And in fact, 12 months out, our forecast of 5,700 for the market is consistent with that trajectory of earnings.
And so the market is fairly valued in present time.
And as equity, earnings are higher over time, then you'll probably get a higher level of market as well.
But within that 12 months, we have a US election.
And you've pointed out that this type of election uncertainty that we're facing can often be really challenging for stocks.
So why are you looking through that potential volatility?
Or are you not? And that's sort of embedded.
I think about the election in a couple of ways.
First, the general pattern historically is that equity prices decline coming into the election.
Volatility increases because of uncertainty and share prices decline slightly.
Once the election is concluded, the uncertainty is resolved.
And history shows that the equity market rallies pretty significantly.
And so that would be a pattern as we think about sitting here today in late June, early July.
You're looking at a situation where there's likely to be some volatility downside risk in the early fall.
And that's likely to be resolved.
And the equity market moves a little bit higher.
That's the first issue.
Second issue is from a policy perspective, tariffs has really been the biggest area of discussion with portfolio managers.
Most recently, and what we find is our portfolio of companies, which is primarily domestically facing in terms of its revenue sources, have outperformed a portfolio, comparable portfolio, that's more internationally exposed.
And the intuition behind that is investors are concerned, effectively, on the retaliatory tariffs that may take place.
And therefore, those companies that are dependent on non-US revenues would be more at risk.
And that has, in fact, in the case, both this year as the probability of Trump presidency has increased, that two baskets of stocks, domestic outperformed international by around five percentage points already.
And then, in fact, was the pattern that we saw in previous years with the idea of rising tariffs when the non-US exposed companies tended to lag.
As a previous forecaster, I think it's always difficult to forecast.
It's going to go down and then it's going to go up.
But that's essentially what the historical pattern has shown around elections.
If you wanted to think about this from the options market, the option market assigns a premium to the options contract in October, which is the forward one month volatility and covers the period of time around the 5th of November, which is the election date.
However, the timing of when the election is ultimately decided may take longer as a consequence, actually, the contract in November may be the more interesting opportunity for institutional investors to think about.
Because that trades at a discount, and the idea of mandatory recounts, voluntary recounts, etc.
may mean a delayed resolution of when the election is finally determined.
And that probably would be perceived pretty negatively.
I would assume my market gets.
The uncertainty. And the uncertainty is likely to be high around this election in particular.
Given that how close it was in 2016 and 2020, and the idea of so many states are quite close, and many states have the requirement that if two candidates are within half a percentage point of one another, there's mandatory recounts.
In other cases, you have states where there's voluntary recounts allowed.
And so this is likely to be potential for a extended period of time to resolve the election.
Yeah, so potentially fun times ahead.
If we think beyond the election risk, what other risk do you focus on that present upside risk or downside risk to your forecast?
The central risk in the market is around the AI topic.
And the reason for that is that as we said at the very beginning, the return to the stock market this year in the United States has been driven to a very significant degree by relatively few number of stocks, all of which are associated with this theme.
And to the extent that investors become more cautious on the economic or financial benefits for companies who are making these investments, that would put the valuations of those particular companies at risk.
They do trade at a meaningful premium.
That certainly was the experience in the.com boom in the late 2000s.
Very, very strong revenue expectations were ultimately not met.
Companies still delivered strong revenue, just not elevated levels that was anticipated.
And as a result, multiples compressed a lot.
So that is a number one risk that's both most proximate and most concerning as an analyst as a strategist.
This obviously is something we focus on a lot.
And when we speak to portfolio managers, we speak to corporates, the questions of how timing and the magnitude of what benefits may near to corporations as a result of all this AI investing is becoming less certain.
Let me throw one more risk into the hat if I may, which is positioning given the outperformance of US stocks and of this handful of US stocks that have driven this outperformance.
Are investors already chock full of these stocks?
Are there any more buyers out there?
There are two sources of demand for shares in the United States right now.
The first is corporate repurchases.
That is the largest source of demand for shares.
Our expectation is that there'll be around $934 billion of demand by companies to repurchase their own shares.
That's the biggest source.
The second source is an interesting one, which is that actively managed equity mutual funds.
Their portfolios are underweight in the largest technology stocks.
And as there has been a secular shift of money going from active to passive products, whether that's an index-related product or an ETF, as money goes from active to passive, there is actually a net buying of these shares.
And so portfolio managers at an active basis are perhaps six, 700 basis points underweight these largest companies.
That is a source of net demand.
And that's an interesting aspect.
That's again in the mutual fund community.
And if you look in the hedge funds, the hedge funds themselves are very significantly overweight.
Their largest positions in fact are the largest companies in the market.
And why are the actively managed mutual funds underweight?
Part of the reason for their being underweight has to do with government regulations and the SEC guidelines on what determines what is allowable for a diversified equity mutual fund requires it to be diversified.
And the concentration of the indexes right now in many cases puts the active manager in a position that he or she has to be diversifying outside of the largest companies simply because they would cause a mutual fund to be in violation of the requirements to be a diversified fund.
And so therefore they are choosing to generate alpha and trying to generate excess returns to other companies.
But again, the idea of these largest companies showing terrific sales growth, high margins, share prices arising has made this more and more challenging as the year has gone long.
And provided more incentive, therefore to move from the actively managed mutual funds to the passive funds, which are exposed to these names.
Correct. Thanks so much for joining me, David.
Great to have you. Thanks, Allison.
This episode of Goldman Sachs exchanges was recorded on Wednesday June 26, 2024.
I'm your host, Allison Nathan.
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