Source: Zhitong Finance Author: Xu Ran

Goldman Sachs's strategists raised the forecast value of the S&P 500 index from 4,700 points to 5,100 points. The main reason for this adjustment is the double expectation that the Fed will cut interest rates.

The Federal Reserve said last week that as inflation falls, it may cut short-term interest rates to ensure continued economic growth. The yield on long-term government debt usually fluctuates according to expectations of short-term interest rates, so the 10-year US Treasury yield has fallen to about 3.9% from a level close to 5% in October.

The first critical factor for the stock market is that inflation-adjusted real yields are also declining. The current yield of 3.9% on 10-year US Treasury bonds, minus the average annual inflation rate for the next 10 years shown by St. Louis Fed data of 2.21%, the actual yield fell to 1.69% from about 2.5% at the end of October.

The lower real yield is a strong shot for the stock market. When secure government bonds become less appealing, investors are more willing to pay more for the profit stream created by stocks. Goldman Sachs's forecast reflects this.

Goldman Sachs said that by the end of 2024, the S&P 500 index should trade 19.9 times the earnings per share expected by its constituent companies for the next year. As of Tuesday's close, the index was around 4,768 points, trading about 19.5 times.

Goldman Sachs chief US equity strategist David Kostin wrote, “Slowing inflation and the Fed's relaxation policy will keep real yields low and support a price-earnings ratio higher than 19 times.”

Of course, maintaining real yields at current levels does not always mean that stocks are so highly valued. In January of this year and October 2022, when the 10-year real yield was about 1.7%, the index's prospective price-earnings ratio was slightly less than 19 times.

Today's glimmer of hope, and the second element of Goldman Sachs's argument, is that the market expects profits to continue to grow — a reason for currently paying high prices to buy stocks to capture future profits. This logic makes sense, given that the economic growth rate has been low to medium single digits over the past few quarters.

Lower interest rates will further stimulate continued demand for goods and services and have a positive impact on sales and profits. Goldman Sachs's model predicts that by 2024, S&P 500's earnings per share will increase 8% to $237. The logic is that sales are likely to increase moderately, while stock buybacks reduce the number of tradable shares and increase the distributable profit per share.

Goldman Sachs expects more growth in 2025, and expects another 8% increase to $256. If the index trades at a ratio of 19.9 times that of the Kostin period, it would bring the S&P 500 index to 5094.4 points, one step away from the bank's target.

The risk is that economic growth may slow in the next few years, but that's for later. Looking at it now, the Federal Reserve is likely to make way for the economy, corporate profits, and the stock market.

edit/lambor