Although major U.S. stock market indexes are poised to set another record high close on Monday, Goldman Sachs equity strategists are advising caution and sticking with their earlier year-end forecast of 2,100 for the S&P 500. That’s 3% below midday levels.

“’Risk-on’ has been the clear mantra since the post-Brexit low. But sentiment can reverse quickly,” according to the latest weekly note from Goldman strategists, led by Chief U.S. Equity Strategist David Kostin.

The Goldman strategists are not only forecasting a year-end close below current levels but another 5% to 10% loss in the meantime before the stock market recovers somewhat.

“Our year-end target remains 2,100 but the path will include a 5% to 10% drawdown during the next few months sparked by rising U.S. and global political uncertainty, negative EPS revisions, decelerating buybacks, and overly dovish policy expectations for the Fed given wage inflation trends,” they write.

These strategists are not buying the popular argument that stocks can continue to trade higher from here so long as interest rates remain at historically low levels, for several reasons:

  • Stock valuations are already at historically high levels. The S&P 500 is trading at a forward price-to-earnings ratio of 17.6%, ranking in the 89th percentile since 1976. Other metrics including Price/Book, and Enterprise Value/EBITDA and EV/Sales are also historically high.
  • Earnings are forecast to continue to decline in the second quarter, which would be the seventh consecutive quarter of declining year-over-year operating earnings. Low rates are especially hard on financial stocks. They impair the net interest income of banks — the difference between the rates they charge on loans and the rates they pay on savings — and make it harder for insurance companies to meet their liabilities. Goldman analysts recently trimmed their earnings forecast for banks by 5% to 7%. (Bank of America on Monday reported an 18% drop in second-quarter profits, driven largely by a 12% decline in net interest income).
  • Low rates hurt the earnings of companies with large pension liabilities. Companies use a discount rate, based on the investment returns of high-quality corporate bonds or Treasuries, to estimate the future investment returns of fund assets that will be used to fund those liabilities. Those liabilities increase when expected returns from high-quality bonds are low because of low yields. Goldman Sachs estimates that continued low yields could reduce S&P 500 operating EPS this year by $2.
  • Increasing wage inflation suggests lower margins and equity valuations. Furthermore, write Goldman strategists, if rising wages increase inflation expectations then the odds of Fed rate hike increase, which would increase bond yields. But the strategists note that higher bond yields combined with a narrower earning risk premium for stocks is consistent with its 2,100 year-end target.

That year-end forecast is the same that Kostin had for year-end 2015. It was at the lower end of what many strategists were expecting, but it came in almost 3% above where the S&P 500 had finished that year, at 2,044. “Flat is the new up in a range-bound market,” according to the strategists’ “Second Half Strategies” report, released earlier in the month.

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