Goldman Sachs gives 3 investment strategies for an expensive stock market
Goldman Sachs has three trading strategies for investors trying to navigate a market that it says has a "historically elevated valuation." The Wall Street investment bank is doubtful stocks can continue marching higher, citing the historically high valuations of the S & P 500 on both an aggregate and equal-weighted basis, according to a note last Friday. The broader index is trading at roughly 20 times price-to-earnings ratio on an aggregate basis (up from 17 times in October), and roughly 16 times on an equal-weighted basis (up from 14 times). In fact, the S & P 500 is currently at about the same valuation Goldman Sachs expected it to end 2024. Goldman Sachs originally expected the S & P 500 would end this year at 4,700, though it has since hiked its target to 5,100, according to the CNBC Strategist Survey. The broader index was last trading around 4,766. "Our model of S & P 500 valuation suggests that the current elevated P/E multiple is appropriate, and we expect the market to trade at roughly the same valuation at yearend 2024," David Kostin wrote. "However, this starting point also implies that valuation expansion is unlikely without a surprising further policy-driven decline in real Treasury yields." Given this, investors looking for value in an overvalued market should try out three different trades. Kostin recommends traders buy small caps; own businesses with poor pricing power, where profits are likely to improve; and choose consumer staples over utilities. Small caps Investors should own small caps this year, Kostin said. The Russell 2000 is expected to rise 15% over the next 12 months, compared to an 8% gain for the S & P 500, the chief U.S. equity strategist said. In fact, he expects small caps should outperform even if the economy does not grow at the rate Kostin expects, with a 2.3% rise in gross domestic product for 2024, given the stocks' low valuations. "The biggest risk is that investor expectations for economic growth deteriorate," Kostin wrote. "However, low valuations provide a buffer: Based on current valuations, our model suggests that small-caps will generate positive returns even if 2024 GDP growth registers below our economists' forecast." Earlier this month, Goldman Sachs predicted some small caps would beat large caps this year. Among the names that made the cut was broadcast and digital media company Tegna , an owner of 64 stations, which is slightly higher this year. It was down about 28% in 2023. Another pick was asset manager WisdomTree , which is up more than 5% in 2024. It surged 27% last year. Weak pricing power Another trade is owning businesses with weak pricing power. Not only are they currently trading at a discount to companies with strong pricing power, but they should get a boost as operating margins improve. Operating margin represents what's left of a company's revenue after paying for operating costs. "Profit margins should also benefit from operating leverage in a solid economic growth environment," Kostin wrote. "During periods of improving profitability, investors often reduce the scarcity premium assigned to strong pricing power stocks, and firms with less pricing power and more variable profit margins typically outperform." Some companies with weak pricing power include Freshpet , according to a Goldman Sachs stock screen. In December, the pet food company was called a best idea for 2024 by TD Cowen, which saw a "clearer path to profitability" for the stock. Freshpet is down 2.5% in 2024, after surging more than 64% in 2023. Roblox was another stock pick, down about 13% in January after gaining 60% last year. D.R. Horton , Texas Roadhouse and Hertz Global Holdings were also recommended. Own consumer staples Meanwhile, consumer staples are at an attractive valuation compared to utilities. Consumer staples' earnings forecasts are nearing a bottom and, in addition, the sector tends to outperform during rate cutting cycles. "Across 8 Fed cutting cycles since 1984, Consumer Staples has outpaced the S & P 500 75% of the time by a median of 7 [percentage points] during the 12 months following the first cut. In contrast, Utilities has outperformed just 25% of the time, lagging by a median of 4 pp," Kostin wrote. Some consumer staples companies that also have weak pricing power include Tyson Foods and Pilgrim's Pride . Tyson shares are up more than 1% this year, after falling 10% last year. Pilgrim's Pride is up 2% this year, adding to its 16% gain last year.