Goldman hasn’t lost that bullish feeling. In their H2 strategy note they detail the reasons why the US equity market is likely to rally 14%+ by year-end:
“Our framework for evaluating the US equity market Our framework for evaluating the US equity market incorporates four pillars – the economy, earnings, valuation, and money flow – and suggests the S & P 500 will rise approximately 14% to reach 1250 by year-end 2010.”
Goldman still believes we are in for an environment of low interest rates:
“Our US Economics team forecasts sustained low-inflation and a Fed on hold until 2012. A low rate / low inflation macro backdrop has historically been associated with positive S & P 500 returns.”
The recovery in the equity markets will be bolstered by three primary factors: earnings, valuations and money flow. Goldman believes equities are not only cheap, but that corporations are in an unprecedented position of strength:
“Earnings: Just as a discussion of the economy is dominated by macro issues, so analysis of earnings is mostly about micro. Business activity at the firm level continues to improve as measured by both the magnitude of upward sales and EPS revisions as well as the breadth of positive earnings revision sentiment. Cyclical sectors have posted the strongest upward EPS revisions . Importantly, analysts boosted the level of expected future profitability (2Q-4Q 2010) after firms announced 1Q results. Our operating EPS estimates for the S & P 500 remain $ 78 for 2010 and $ 93 for 2011. Our pre-provision and pre-write-down estimates equal $ 83 and $ 93, respectively, reflecting annual growth rates of 15% and 12%. Our earnings estimates imply negative revisions to bottom-up consensus EPS estimates of $ 82 in 2010 and $ 97 in 2011. The bear case on earnings rests on the belief that the macro data in 2H will lead to negative EPS revisions. However, forward-looking commentary at the micro or company level is not consistent with an imminent economic slowdown that many expect at the macro level.
Valuation: Both macro and micro approaches to valuation suggest US equities are undervalued. The Fed model (a macro or top down approach) suggests the S & P 500 trades 25% below fair value while P / E multiple mean reversion (micro or bottom-up) implies the undervaluation is closer to 40%. We anticipate the market will rise by 6% to 1160 over the next three months, rise 14% to reach 1250 by year-end 2010, and reach 1300 in 12-months representing a return of 19%. The S & P 500 currently trades at 12.2 x our pre-provision and write-down NTM EPS estimate. Should the market reach 1250 it would reflect a P / E multiple of 13.4x NTM EPS. A rally of 14% to year-end would rank in the 86 th percentile of six month returns since 1950 and represent a full-year 2010 return of 12%, ranking in the 59 th percentile.
Money Flow: The bear case in every client discussion relates to the contagion effect if Europe’s sovereign debt problems spread across the Atlantic Ocean. Although Federal, state, and individual balance sheets remain in extremely weak condition, corporate balance sheets remain the strongest in history. S & P 500 non-Financials cash totals $ 973 billion, and the cash / asset ratio of 10.4% is near the highest in history (2.5 standard deviations above average).”
How to play it? Goldman says we are in the “late recovery” phase. They are overweight IT, industrials, consumer staples and energy: