"We expect S&P 500 will rise by 5% to 1750 by year-end 2013, advance by 9% to 1900 in 2014, and climb by 10% to 2100 in 2015," says Goldman's Chief U.S. Equity Strategist
David Kostin in a note to clients.
Including dividends, this would represent a 33% total return through 2015.
The key component underlying the bullish call on the stock market is the investment bank's outlook for an improving U.S. economy, which will cause further expansion of the price-to-earnings (P/E) ratio – the valuation multiple investors pay to own stocks.
Multiple expansion, Kostin points out, already accounts for three quarters of the market's gains in the rally that has taken place throughout 2013 already, with only one quarter of the price appreciation due to increases in earnings.
"Our U.S. economists forecast above-trend growth in 2014 for the first time in six years," says Kostin. "In advanced economies, the final year of economic stagnation before GDP growth exceeded trend has been associated with P/E multiple expansions averaging 15%."
The note goes into a bit more detail on why Goldman expects multiple expansion to drive the market higher. Here is the key section:
Our year-end 2013 forward P/E of 15x would be 14% above last year’s 13.2x. The S&P 500 currently trades at 14.6x bottom-up consensus and 15.0x our top-down NTM EPS estimates.
The macro investment environment supports an above-average S&P 500 valuation. Our standard valuation approaches point to a P/E multiple of 14x forward earnings. However, our revised forecast estimates an S&P 500 P/E multiple of 15x-16x during the next three years that is above the long-term average but in line with the post-1990 experience. The S&P 500 forward P/E multiple has averaged 12.9x since 1973 but 15.3x since 1990.
Changes to our S&P 500 return forecasts reflect a one P/E multiple point premium to our fair-value estimates. Reasons for a higher multiple include increased confidence in the medium-term outlook for US economic growth, improving investor risk appetite, and the wide gap between equity and bond yields that we now assume will be closed more by stocks than bonds. Sustained Fed commitment to monetary easing, aggressive measures by the Bank of Japan, and persistent weakness in Europe growth mean US Treasury yields may remain low despite strengthening domestic growth.
One of the biggest open questions in markets is how bond yields will affect the market once they begin to rise, but Goldman isn't worried.
"We believe equity markets will continue to perform well even if US Treasury yields rise provided the higher rates stem from improving economic growth prospects," Kostin says.
Here's a summary of their call:
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