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"Consequently, three questions dominated discussions this week: (1) the forward path of the US equity market; (2) prospective return of the S&P 500 compared with other global stock markets; and (3) investment strategies through year-end after a stellar 22% rally during the first 10 months of 2013."
On the first question, Kostin says the debate can be characterized in two words: "Fama vs. Shiller" (the names of two economists who won this year's Nobel Prize in economics).
He writes:
Bullish investors point to Fama's "efficient market" thesis and argue that current prices incorporate all known information. Put simply, the stock market always trades at fair value. Stated alternatively, the 17% YTD P/E multiple expansion reflects improved domestic economic fundamentals and the expectation of sustained low interest rates. Goldman Sachs US Economics believes the tapering of QE3 will not begin until March, However, many investors believe the Fed will not curtail its bond-buying before June.
Several of the approaches we use to estimate the fair value of the stock market support the current level of roughly 1750. For example, the return on equity (ROE) for the S&P 500 equals 15.5%, a level of profitability that is typically associated with a Price/Book Value (P/B) ratio of 2.5x. S&P 500 now trades at 2.6x trailing book value, in-line with the 10-year average.
During nine P/E multiple expansion cycles since 1982 S&P 500 troughed at an average of 10x and peaked at an average of 15x. Consistent with this pattern, the current cycle started in September 2011 at 10.6x and the S&P 500 now trades at 15.5x our top-down EPS estimate of $116 for 2014 and 15.2x consensus bottom-up forecast of $121.
In contrast with efficient market disciples, behavioral economists believe markets sometimes deviate from fair value. The cyclically- adjusted P/E ratio (CAPE) popularized by Robert Shiller values the market using trailing ten year reported earnings. According to this metric, S&P 500 now trades at 24.5x. If the market reverted to its 80-year average CAPE of 17.7x the S&P 500 index would trade at roughly 1450 or 30% below the current level.
Kostin says Goldman's house view is that the "S&P 500 trades at fair value and the forward path of the index will follow the trajectory of profit growth." The bank estimates S&P 500 EPS of $108 in 2013, $116 in 2014, $124 in 2015, and $131 in 2016.
On the second question, Kostin says the prospects for U.S. stocks pale in comparison with those for Japanese and European equities.
We forecast TOPIX will gain 16% to 1400 by the end of 3Q 2014," he writes. "Our prospective 12-month S&P 500 return of 6% also trails Europe where we expect Stoxx 600 will gain 9% to our target of 350."
As far as trading strategies over the next two months go, Kostin believes the best bet is stocks with high total cash return, as he thinks the S&P 500 will trade sideways through the remainder of the year.
"When the S&P 500 trades in a +/-5% band during a three-month period, stocks with a combination of high buyback yield and dividend yield have outperformed 72% of the time since 1995," he says.
Stocks in Goldman's "total cash return to shareholders basket" include GME, RAI, MPC, AIG, PFE, PNR, YHOO, ARG, T, & DUK, among others.