Goldman Sachs Chief U.S. Equity Strategist David Kostin is bumping up the bank’s year-end S&P 500 price target to 1625 from 1575.In a note to clients this morning, Kostin writes, “The 2013 US equity market story is becoming one of improving business activity accompanied by increased CEO confidence,” pointing to recent positive surprises in employment, manufacturing, and retail sales data.
Accompanying all of that is a forecast for 2 per cent GDP growth in 2013 and 2.9 per cent growth in 2014, with 10-year Treasury yields rising to 2.5 per cent by the end of the year and 3.0 per cent by the end of 2014.
“The ‘sequester’ has begun and the federal government is still functioning,” says Kostin.
Below is Goldman’s thesis:
We lift our year-end 2013 index target to 1625 (from 1575) reflecting a modest 4% rise from the current level. US equities currently trade near fair value based on various metrics as well as our macroeconomic regression model, our dividend discount model (DDM), and the relationship between return on equity (ROE) and price/book value. S&P 500 trades at 13.9x bottom-up consensus forward EPS, near the average of the past decade, but well above the 12.9x average forward P/E since 1976. Fed model suggests 14% upside by year-end 2013 while the cyclically-adjusted P/E ratio points to 7% downside.
We recommend cyclical exposure rather than defensive tilt. Financials, along with Industrials and Materials, should outperform. The thesis behind our bullish view on Financials involves accelerating economic growth, rising 10-year interest rates, improving ROE, and rising dividends and buybacks. We lower Information Technology to Neutral.
However, the call doesn’t come without risks, Kostin writes:
Risks: Margins downside, multiple upside, mixed response to higher interest rates.
First, earnings will be lower than we currently forecast if margins are squeezed because firms are unable to pass through higher input costs. Upside opportunity may exist from a higher P/E multiple if US equities receive more inflows in 2013 than our current $200 billion estimate. The impact of rising bonds yields on stock prices and valuation will depend on whether it stems from growth or inflation. Faster economic growth would support higher EPS and potentially lead to an expanding P/E and a rising equity market. In our view the risk of higher inflation appears modest in an environment of 7.7% unemployment.
Money flow is difficult to forecast. Many investors cite the potential for a “great rotation” from bonds to stocks. Despite share prices more than doubling, the high S&P 500 drawdown during recent years actually spurred risk-averse retail investors to shift assets into bond funds and away from stocks. We expect this pattern will persist until 10-year US Treasury yields reach 3%. Asset reallocation is likely to be a key theme in 2014 rather than this year.
Goldman is also lifting its 2013 S&P 500 earnings forecast to $108 from $107 and its 2014 forecast to $116 from $114.
In other words, the call relies on the fundamentals – a continued improvement in the economic data and the argument that this is not the peak for profit margins.
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