GOLDMAN: One measure suggests stocks could crash 25%

The S&P 500 is looking a little pricey, according to Goldman Sachs’ David Kostin.

Kostin, Goldman’s chief equity strategist, said in a note to clients that even though companies in the S&P 500 are becoming less and less profitable, they are not being penalised by investors.

“The historical relationship between return on equity (ROE) and price/book (P/B) shows investors penalise falling profitability with lower valuation,” wrote Kostin. “However, despite the steady 200 bp decline in S&P 500 ROE to 14.1% during the past 8 quarters, P/B has actually expanded to 2.8x and is above the 40-year average of 2.5x.”

ROE measures how much profit a firm generates for every $1 of shareholder equity. Thus, as ROE falls, this means that companies are making less per dollar of share value.

Additionally, price-to-book measures the value of a company similarly to price-to-earnings (P/E). Instead of measuring against profits, like P/E, P/B measures profit against all the assets that the company holds and could be sold if it were to liquidates, or its book value.

Based on the current ROE of the aggregate S&P 500, according to Kostin, there is significant reason to believe there is some downside.

“Based on history, an index-level ROE of 14% implies a P/B of 2.1x, suggesting index downside of 25%,” said Kostin. “Valuation of the median S&P 500 constituent is elevated relative to the aggregate index with a P/B of 3.1x and ROE of 16%.”

Put another way, based on the historic correlation between ROE and P/B, the price side of price-to-book should likely fall to bring it more into line with historical trends.

Kostin has been warning about a possible pullback in equities for some time, as the market appears to be expensive compared to its historical average based on a number of metrics. This is another metric in that pullback narrative.

The Goldman strategist has a year-end price target for the S&P 500 of 2100, it closed on Friday at $2139.16.

NOW WATCH: STIGLITZ: It makes me crazy that everyone gets this wrong about the economy

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.