Goldman Sees Value Outside of 'Stretched' U.S. Equities

Seven months after the Federal Reserve warned that valuations of some smaller, biotechnology and social-media stocks may be "stretched" in the U.S., Goldman Sachs Group Inc. is using the same word to describe the whole shebang.

By InvestSMART · 24 Feb 2015

By InvestSMART ·
24 Feb 2015

Goldman suggests investors look abroad.

Seven months after the Federal Reserve warned that valuations of some smaller, biotechnology and social-media stocks may be “stretched” in the U.S., Goldman Sachs Group Inc. is using the same word to describe the whole shebang.

“Stocks with attractive valuation are rare in the current environment of stretched share prices,” Goldman’s chief U.S. equity strategist David Kostin and colleagues wrote in a Feb. 20 report, citing the ratio of price to estimates of future profit and the ratio of enterprise value to earnings before interest, taxes, depreciation and amortization. “The only time during the past 40 years that the index traded at a higher multiple was during the 1997-2000 Tech Bubble.”

“Stretched” valuations sound scary, but here’s something that may be even scarier: missing out on an 80 percent rally over the following three years because you got out of stocks when the market looked stretched. That would’ve been the case in 1997 when the Standard & Poor’s 500 Index first got to the valuation of 17.3 times estimated earnings for the next 12 months, which is also where it’s trading these days.

What’s happened since the Fed’s remarks about stretched valuations seven months ago? Well, the S&P 500 has gained almost 7 percent, the Nasdaq Composite Index is up 12 percent and the Russell 2000 Index of small caps is more than 5 percent higher. While the Solactive Social Media Index is down about 2 percent since then, the Nasdaq Biotechnology Index has surged more than 30 percent.

Bubble Ghost

The tech bubble, of course, has been the ghost that haunts the current bull market more and more loudly the longer the rally endures. The Nasdaq Composite is making a run for the peak it reached during that bubble almost 15 years ago, albeit at valuations that are a fraction of what they were then. A gain of less than 2 percent in the index will finally make it the last of the most closely-watched broad-market gauges to reach a record.

Common sense would suggest that the hard-earned collective wisdom of equity investors means valuations will never get as stretched as they did in the tech bubble, when the S&P 500 peaked at more than 25 times forward earnings, according to data compiled by Bloomberg. Yet identifying valuations that are “stretched” is easy. Identifying valuations that are stretched to the breaking point is harder.

‘Smart Money’

How stretched is too stretched? Who knows. At Goldman Sachs, Kostin and company believe things are as stretched as they’re going to get on the macro level. In their view, the S&P 500’s price-to-earnings ratio should contract as the Fed begins to raise interest rates in September and the index will end the year at about 2,100, right around where it is now.

“The proverbial ‘smart money’ is selling, not buying,” they write, adding that completed private equity sales through mergers and acquisitions and follow-on offerings have reached record levels.

Investors looking for more attractive valuations need to go outside the U.S., according to Kostin’s team, provided they use currency hedges. (That seems to be a popular trade du jour, given the surging popularity of the WisdomTree Europe Hedged Equity Fund.) Goldman is forecasting 12-month, local-currency returns of 19 percent for Japan’s Topix Index, 17 percent for the Stoxx Europe 600 Index, where central bank easing is about to heat up big time, and 15 percent for an index tracking Asian nations besides Japan.

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