Rally on despite markets being powered to records by a handful of very large stocks, says David Kostin, Goldman Sachs chief U.S. equity strategist.
Goldman's research shows that five stocks have accounted for 51% of the S&P 500’s return since the end of April. Those five stocks — Microsoft, Google, Apple, Nvidia and Tesla — account for more than one-third of the S&P 500s 26% return this year.
While this has unfolded among these household name tech giants, Kostin points to narrowing market breadth (or fewer stocks participating in the rally) underneath the surface as a key near-term risk to markets.
"Following periods of sharply narrowing market breadth – similar to the recent experience – equities have historically exhibited weaker-than-average returns and deeper drawdowns," Kostin says.
Since 1980, there have been 11 times in which market breadth has narrowed by as much during a six-month period as it did from April to October of this year. Following most of these episodes, Kostin finds the S&P 500 has generated below average returns over the following one, three, six and 12 months.
"Our previous analysis shows that changes in market breadth can be a useful signal for near-term equity market returns," Kostin adds.
That said, Kostin believes stocks are poised to break from this historical trend due to several factors.
"While 'unknown unknowns' cause the largest drawdowns and by their nature are impossible to assess in advance, the macro environment does not suggest drawdown risk is elevated in the coming months. While difficult to predict, the risk of a recession appears low. Earnings and margins continue to surpass expectations. Meanwhile nominal and real rates are expected to rise but remain low over the coming months, supporting the backdrop for both valuation and equity demand," Kostin explains on his upbeat outlook for the markets.
The strategist is bullish on high growth stocks.
Adds Kostin, "These stocks have performed well in recent months and this should continue provided narrowing breadth persists. Such firms trade at only a small premium to similarly high growth companies with low or negative margins. High margins are a signal of quality and indicate these stocks are likely to outperform their low margin counterparts amid an uncertain macro backdrop and tightening financial conditions."