Throughout the first half of the year, as stocks kept grinding ever higher and Goldman issued one after another bearish equity strategy note, the bank's chief equity analyst David Kostin stubbornly kept Goldman's S&P price target at 2,300. Now, "unexpectedly" with stocks finally cracking with some violent moves in the tech sector after repeated warnings by top Fed bankers that stock "valuations are too rich", moments ago Kostin just raised Goldman's year end price target from 2,300 to 2,400. "reflecting a 1% decline over the next six months."
Key highlights from his note below:
We raise our year-end 2017 S&P 500 price target to 2400 from 2300, reflecting a 1% decline over the next six months. This return would represent a 27th percentile event since 1975. We expect EPS growth of 9% this year will be offset by a 4% contraction in the forward P/E multiple to 17.3x from 18.1x. The prospect of accelerating inflation, higher policy rates, and rising 10-year bond yields will weigh on S&P 500 valuation. Our 12-month price target of 2450 represents a 1% price gain (+3% total return including dividends). A lower-than-expected rate of inflation and persistently low bond yields would support a higher level of the market.
We increase our S&P 500 adjusted EPS estimates to $129 in 2017 and $139 in 2018 (from $123 and $129). The increase stems from strong 1Q results and higher expected growth in Financials and Info Tech. We expect S&P 500 sales will grow by 5% in 2017 and 2018 and margins will expand by 22 bp to 9.7% in 2017 before peaking at 9.9% in 2018. Our forecast assumes average 2017 US GDP growth of 2.1%, average 10-year US Treasury yields of 2.6%, and no change in corporate tax rates. See Exhibit 9 for a sensitivity of our EPS estimates to macro variables.
Here are the details on why, just as the IMF slashed its US GDP forecast, Goldman is expecting even more profit upside:
We lift our 2017 and 2018 S&P 500 adjusted EPS estimates to $129 and $139 (from $123 and $129), representing annual growth of 9% and 7%. The increase is driven by stronger than expected results in 1Q and higher estimates in Financials and Info Tech. We raise our operating EPS estimates to $121 and $130 in 2017 and 2018 (from $116 and $122). We expect S&P 500 sales will grow by 5% in 2017 and 2018 reflecting modest US GDP growth and accelerating inflation. We lift our S&P 500 profit margin forecast on the back of solid 1Q economic activity, strong Info Tech margins, and a rebound in Energy margins.
Our sales, margins, and earnings models incorporate forecasts for a variety of macroeconomic variables. Our US Economics team expects modest economic growth in 2017 and 2018. They also forecast that a tight labor market will push wages and inflation higher, with core CPI and core PCE reaching 2.2% and 1.9% in 2018, respectively.
Following a rebound in 2017, we expect S&P 500 sales and EPS growth will decelerate through 2020. 2017 sales growth of 5% and EPS growth of 9% would represent the fastest pace of growth since 2011. However, given late-cycle dynamics, we expect positive but decelerating sales and earnings growth going forward.
We expect S&P 500 margins will rise modestly to 9.7% in 2017, before peaking at 9.9% in 2018. After reaching an all-time high of 9.7% in 3Q 2015, the decline in Brent oil prices from $53 to $28 drove S&P 500 margins lower. However, excluding Energy, S&P 500 margins continued to move higher and reached a peak of 10.4% in 1Q 2017. We expect margins will gradually expand through 2018, in part due to the rebound in Energy margins, but our estimates remain below consensus expectations of 9.8% in 2017 and 10.4% in 2018. In 2019 and 2020, slowing economic growth, a tight labor market and rising wages, and higher inflation will result in S&P 500 margin contraction.
As a result of the above changes, Goldman has increased its S&P 500 operating EPS estimates to $121 and $130 (from $116 and $122). The 69% collapse in oil prices from $115 in 2014 to $36 in 2015 prompted ceiling cost write-downs by Energy companies, increasing the gap between S&P 500 operating and adjusted EPS to a peak of $17 (or 18% of EPS). The gap narrowed to $13 in 2016 alongside a rebound in commodity prices and we estimate it will continue to fall to $9 in 2017 and 2018. To this Goldman believes that the period of significant Energy asset write-downs is likely behind us, unless of course oil plunges back under $40 as UBS calculates on Monday, in which case all bets are off. "We expect stock-based compensation (Information Technology) and the amortization of goodwill (Health Care) will continue to be the key drivers of the roughly $8 annual gap going forward."
Finally, this is what the revision in EPS outlook means to the S&P, or how Goldman goalseeked its 100 points S&P price target increase from 2,300 to 2,400:
We continue to expect that solid S&P 500 earnings growth will be offset by a contraction in the forward P/E multiple. Concurrent with our upward EPS revisions, we lift our year-end 2017 price target to 2400 from 2300 previously. We also increase our 2018 and 2019 S&P 500 price targets by 100 points each year to 2500 and 2600, respectively. Accelerating inflation, rising interest rates, and stretched valuations relative to history will weigh on valuation and lead to a decline in the forward P/E from 18.1x currently to 17.3x in 2017 and 17.1x in 2018. Our year-end 2017 target suggests a slight 1% decline in price, which would rank as a 27th percentile six-month return since 1975. Downside risks include a more hawkish Fed than priced in the futures market, higher-than-expected inflation, and upcoming political uncertainty surrounding the federal debt ceiling. Looking further in the future, our price targets imply 4% annual price gains in 2018 and 2019 (6% annual total return including dividends).