Goldman Sachs strategists said in a recent report that the premium for high-quality U.S. stocks is declining as economic conditions normalize.
The Wall Street giant highlighted that the current premium for "quality" stocks is at a historically high level, reflecting the strong market demand for companies with superior returns on capital, profit margins and balance sheets. The widening profitability gap among companies in the S&P 500 has been a key driver of this valuation premium.
Goldman Sachs said the current profitability gap, especially the ROE gap between stocks with the highest and lowest ROE (return on equity), has reached 45 percentage points, close to the largest gap since the 1980s.
“The long portion of our sector neutral return factor (which sorts stocks based on return on capital, return on assets, and return on equity) currently trades at a valuation premium of 56%. Compared to history, this premium is currently in the 97th percentile,” the strategists said in a note.
However, Goldman Sachs believes that these elevated premiums could begin to return to historical norms, especially if economic growth remains strong and the Federal Reserve continues its monetary easing cycle.
“Against the backdrop of strong GDP growth and the start of a Fed rate-cutting cycle, paying an excessive premium for profitability and other ‘quality’ factors does not seem justified,” the report said.
Goldman also noted that lower labor costs and lower interest rates could support ROEs in the near term, reducing the need for investors to pay a premium for quality.
“Corporate borrowing costs typically lag changes in interest rates,” the strategists explained. “With the 10-year Treasury yield peaking in October 2023 and subsequently declining, borrowing costs should also decline and cease to be a drag on ROE in the near term.”
For this week, a team of Goldman Sachs analysts led by David Kostin wrote that if the Labor Department releases strong jobs data on Friday, it could prompt some investors to "lower their expectations for a much weaker labor market," causing them to "rotate money from expensive 'quality' stocks to less popular, lower-quality companies."
U.S. stocks have returned to all-time highs as investors bet that the U.S. economy can avoid a recession on the back of loose monetary policy. The nonfarm payrolls report is in focus this week and is expected to show the labor market remains healthy but growth is slowing.
The so-called quality strategy, in which investors target the most profitable stocks, is one of the five best-performing strategies in the United States this year, according to a factor analysis by Reuters.
Morgan Stanley’s Michael Wilson also recently noted that the labor market will have a bigger impact on stocks than the interest rate outlook. The strategist reiterated in a note Sunday that he prefers large-cap stocks and higher-quality sectors.
Article forwarded from: Jinshi Data
