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Goldman Sachs ups its near-term S&P 500 target due to brighter economic picture. But here’s what the bank’s strategists say could knock 25% off stocks.

MarketWatch logo MarketWatch 2/7/2023 Barbara Kollmeyer
© angela weiss/Agence France-Presse/Getty Images

CORRECTION: Editor’s note: The headline on a previous version of this story gave an inaccurate description of what could cause a market drop. The story has been corrected.

Provided there are no more economic surprises, stocks are unlikely to face a near-term meltdown and the S&P 500 could work its way back to 4,000.

That’s according to a team of Goldman Sachs strategists led by David Kostin. The team lifted their three-month target on the index which has climbed more than 7% so far this year, to 4,000 from 3,600. But Goldman left its year-end forecast at 4,000, roughly in the middle of a Wall Street forecast target range of 3,400 to 4,500.

Explaining the near-term optimism in a note to clients late Friday, Kostin, chief U.S. equity strategist at Goldman Sachs said resilient U.S. macro data has outweighed a thus far “unspectacular” fourth-quarter reporting season. Some might say the U.S. data is a little too resilient after Friday’s employment report showed huge job growth of over half a million, far stronger than expected, which weighed on U.S. stocks again on Monday, with the S&P 500 hovering at 4,101.

Adding to that positive U.S. economic picture was China’s earlier-than-expected reopening and reduced chances of a Europe recession, the team said, noting that still-light institutional positioning means the market could temporarily overshoot their bank’s 4,000 target.

But the strategists drew a line under that cheerfulness, noting that because a soft economic landing is already priced into U.S. stocks, their year-end target is staying where it was for now. They noted that an outperformance of cyclicals versus defensives implies U.S. real economic growth of 2% against Goldman’s own below-trend forecast of 1% gross domestic product in 2023, and an ISM Manufacturing index of around 55 versus a recent 47 reading.

Read: The next few days may reveal whether investors have been riding one big suckers rally, says this strategist.

The bank has a baseline earnings-per-share-forecast of 0% for 2023 and 5% for 2024, versus consensus figures of 1% and 12%, respectively. The strategists said analyst expectations, down 10% since the end of June 2023, are double the historical pace of negative revisions.

Valuations are also already stretched and will be constrained by an eventual rise in interest rates, Kostin and the team said. “The S&P 500 trades at 18.4 [times] forward earnings, and at an even higher ‘effective’ multiple if one accounts for the fact that most investors appear to expect earnings well below those of analyst estimate,” they said.

Kostin and the team said equities can digest rising rates if that change is driven by improved growth expectations. But they don’t see much more value expansion as Treasury yields continue to rise — they see 10-year nominal yields rising gradually to 4.2%.

Also read: How the U.S. dollar could put this stock-market rally to a big test

Given that their own base case for the S&P 500 already has limited upside, a recession could trigger a “substantial downside” for stocks, they warned. They say the index could drop 25% from current levels, landing at around 3,150 under such a scenario, driven by falling earnings estimates and a price-earnings multiple dropping to 14 times from a current 18.

Another risk is that inflation continues slowing but fails to approach the Fed’s target, which could trigger tighter monetary policy and higher interest rates. Lastly, they remind investors that wrangling over the U.S. debt ceiling, which could come later this year, has the potential to damage stocks as it did in 2011, when the market fell 17%.

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