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The stock market faces several risks soon: Goldman Sachs’ Kostin

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Yahoo Finance’s Brian Sozzi and Myles Udland break down today’s market action and outlook with David Kostin, Goldman Sachs U.S. Equity Strategist.

Video Transcript


BRIAN SOZZI: Investors have a lot on their plates right now. Is the Fed going to upend the market by aggressively tapering its bond purchases? Can the bull market withstand corporate tax hikes, which are likely coming soon? And will-- will the retail investor stay as engaged in the markets for the rest of the year as they have been so far?

Luckily, we have Goldman Sachs Chief US Equity strategist, David Kostin, here to help figure all this really crazy stuff out. David, good to-- good to finally speak with you here. You know, I was out-- I've been out recently. I went to my local restaurant. Restaurants are absolutely packed.

I'm trying to buy clothes online. I can't find anything, everything's out of stock. From where you sit, do you think the US economy is overheating as we sit here today? And what are the implications of an overheating economy to the stock market?

DAVID KOSTIN: Well, the idea of overheating economy maybe it's-- I wouldn't agree with that particular description. I would say certainly the rate of growth is well above the long term average, and that would probably reflect the reopening that you referenced specifically, which is idea on our metrics. The idea of the reopening scale index if one is a full lockdown and 10 is fully reopened, we're now at eight.

And that's a whole variety of individual metrics and different industry. So the idea we've climbed significantly back is also consistent with the idea of the economy is growing at a very, very rapid pace. Now, what that means for equity investors is we're likely to see a deceleration in economic growth as we look through the balance of 2021. And more importantly, look into 2022.

So, make no mistake about it, most of the portfolio managers with whom I am speaking now, across the institutional universe, are really focusing on the growth outlook for 2022. So, the idea of the economy slowing is focusing people's attention on companies with more durable prospects in terms of their profit outlook.

And so how do we find that? What do we think about that as a portfolio manager? Well, there's a couple of ideas. One is those companies that have stable margins, high and stable gross margins, that go specifically to your observation, which is there's a sort of supply chain disruptions and a lot of activity, where companies that have the ability to maintain those margins, that's I think an important attribute, sort of that's number one.

And number two, companies that are really leaning in to the economic growth, and how would you think about that? One way we think about that is companies that have been investing for growth for the last several years. So, we want to think about this in the following way. The typical company reinvests as a growth reinvest the ratio of around 11% of its cash flow from operations.

So, think about that, if you take all of the capital spending that a company does. A whole bunch of it is really maintenance Capex. That keep the lights on, keep the business operating. So, we're really focusing on the incremental amount, the growth Capex, plus think about the research and development dollars.

You take that money, that's like 11% of the cash flow from operations. There are companies on the other hand that are investing 75%, have been consistently. And so, that is the idea of companies with high capital investments are likely to position themselves for better growth in 2022. So, going back to your question, we think about it as the economy is growing really rapidly.

Part of it is a base effect, part of it is the idea of reopening, the vaccinations, and all these good things that are happening here in the US as we look at that decelerating growth, what stocks do well and what stocks do we expect will do well, are those that have some of those attributes I just mentioned.

BRIAN SOZZI: And David, against that backdrop of slowing or decelerating growth in the back 1/2 of this year. How could-- how good could-- how good could it get for the S&P 500? What's your upside target?

DAVID KOSTIN: Well, for this year, target for the S&P 500 is around 4,300, which a quick look at the markets today will tell you that's pretty much a flat, slightly maybe 1% kind of upside. So, pretty modest trajectory of growth. We'll call that kind of flattish. But if I look into 2022, the prospects are a little bit better. And so, the end of 2022, our forecast for the S&P 500, 4,600.

So, around 7% or so into-- into the following year. Plus, you can think about a 2% dividend yield. I know you were just talking in the previous segment about the banks in particular, but lots of companies in the position to be raising their dividend. So, the idea, relatively flat trajectory for the balance this year. Maybe upward sloping for next year, largely driven, more importantly, by earnings growth.

A really important point is that the valuation of the market is extremely high on an absolute basis. And even when we adjusted for the very low interest rate environment, historically speaking, our view is that the 10-year treasury yield will be climbing towards around 1.9% at the end of this year. So, that's about 50 basis point backup.

So I think you've got two big headwinds facing the market in the next six months. I think that's what analytically is likely to restrain the appreciation. First issue is higher rates. I just mentioned, the idea of higher rates typically associated with some lower valuations, or if you will, maintaining these levels of valuation. So, that's one issue.

Second issue is tax reform. We're sitting here today literally on the-- the middle of the year, and that is likely to be the dominant topic policy wise in the next several months in Congress, as they negotiate both potential for higher corporate tax rates, and the potential for higher capital gains rates. Those actually affect the market two different ways.

Higher corporate tax rates likely to reduce the level of earnings. In particular, we're looking at 2022. And so, the idea of our estimates, Goldman Sachs, around $202 of earnings for next year. The consensus currently is around $211. So, that would suggest, in our work, that there's negative earnings revision potential, negative EPS revision potential, usually-- negative earnings which is likely to lead to, if you will, a potentially lower market or at least a market that's more stable.

So, that's an earnings transmission mechanism. The second issue is relating to the idea of potentially higher capital gains rates. Well, history shows that when capital gains rates have been or have been increased historically, when those are increasing, that is associated with a flat to slightly lower equity market. That's another potential risk.

So, you have both higher rates and two forms of higher tax rates, capital gains and income-- and corporate tax rates, which I think are going to be central issues facing the market in the next several months. Then once you get past that, the history of capital gains rates previously, tax rates go higher, and in the subsequent six months, a lot of that weakness gets reversed. That's why at 2022 somewhat more optimistic maybe the next six months, which is likely to be flat in our work, our analysis.

MYLES UDLAND: And David, thinking a little bit more about those tax implications. I think back to how the market anticipated the reform in 2017. And then when the event came through, it may not have been as exciting for the market as-- as that anticipatory six months or so. How are you guys thinking about the pricing in question, which is an inevitable sort of in your line of work, on how taxes may manifest within the S&P itself?

DAVID KOSTIN: Absolutely. It really, at the end of the day, it matters what the market's paying for, how do they think about those issues. So, what happened in 2020-- 2017 was the clarity of what the tax reform was going to be, even the fact it was going to pass, really didn't begin to crystallize until the beginning of December in 2017. Ultimately, the legislation was passed and signed into law around December 22.

So, it all happened very, very quickly. And in fact, the earnings revisions for the market, the different analysts, that really had a pretty long tail relative to history. It didn't happen in some ways until March, because companies were looking to close their books at the end of the year. There was a new tax regime, tax lawyers, accountants, treasurers, chief financial officers, analysts still coming to the realization of all the different attributes of the tax code.

So, the trade, if you will, for taxes right now would be to own US companies that have-- if they already have-- have already paid relatively high taxes, those that are currently paying relatively low tax rates would clearly be vulnerable to having a higher tax rate imposed on their earnings.

And so, that's a question that goes back to a point I made earlier, those companies that have high and stable gross margins perhaps are best positioned to-- to kind of weather the higher tax rates. So, right now, the market is not fully paying for this, and there's a specific reason for that.

Market isn't penalizing or rewarding companies either high or low tax rates, because there's a lot of things to be negotiated. There's really two parts of it, which is, is it going to be more acute in terms of the potential higher tax rates on non-US revenues, the so-called GILTI income, you know, global intangible taxes, tax rates, or is it going to be more targeted towards the domestic revenues?

And so, those are obviously going to be affecting-- they would affect different-- different types of companies. And so, we think about when does the market trade for the-- when will it trade this? Well, we're sitting in the middle of the year, more likely than not, something and later in the summer, when there's a little more clarity.

Right now, lots of uncertainty around the budget issues, from a fiscal point of view, as well as the how to try to pay for that and a lot of things that are uncertain. So, I think this experience is likely to be probably at the end of the summer, or kind of early fall. Our expectation is you probably get that maybe September, October type of legislation, that sort of timetable, it seems more-- most probable.

BRIAN SOZZI: Gave us a lot to think about David. We'll have to have you back to talk more about it. I'm getting the hook for the segment in my ear, unfortunately, but I look forward to talking with you again soon. Goldman Sachs Chief US Equity Strategist, David Kostin. Have a great July 4th weekend. Always enjoy your work.