US stocks ‘increasingly vulnerable to a correction’: Goldman Sachs

Goldman Sachs’ top equity strategist warns US stocks are “priced for perfection” and “increasingly vulnerable to a correction” after an exceptional rise in past years.

Goldman Sachs chief global equity strategist Peter Oppenheimer. Picture: Supplied

It has been a great run, but US stocks are now “priced for perfection” and “increasingly vulnerable to a correction”, according to Goldman Sachs chief global equity strategist Peter Oppenheimer.

Falling interest rates and economic expansion have generally been associated with rising stock prices in the past, but the highly-regarded strategist warns of a correction which may be sparked by a sell-off in bonds, disappointments in US economic data or underwhelming earnings.

“Despite the favourable backdrop, the set-up for equities as we enter 2025 is complicated by three main factors,” Mr Oppenheimer said. “First, the speed of the recent rises in stock prices has reflected much of the good news that we are expecting on growth. Second, high valuations are likely to limit forward returns. Third, unusually high market concentration increases portfolio risks.”

The US market dominated in 2024, adding $US10tn ($A16.13 trillion) of value.

It’s now worth 50 per cent more than the combined value of markets in Europe, China and Hong Kong. Big tech has generated most of the returns, with the Magnificent 7 now worth more than the entire European market. The five biggest stocks in the US account for roughly a quarter of the S&P 500.

“The powerful rally in recent months leaves equities ‘priced for perfection’,” Mr Oppenheimer said.

A 47 per cent rise in the S&P 500 over the past two years was nearly the biggest in 100 years.

“While we expect equity markets to make further progress over the year as a whole — largely driven by earnings — they are increasingly vulnerable to a correction driven either by further rises in bond yields and/or disappointments on growth in economic data or earnings,” he added.

Much of the rise in US stock prices has reflected surprising economic resilience.

But, apart from Asia and emerging markets, rising valuations significantly contributed to performance in 2024, accounting for nearly half the return for the MSCI AC World index.

Next 12-month PE valuations for US stocks have hit 20-year highs of 22.2x for the S&P 500 and 19.3x for the index excluding big tech stocks.

While other equity markets look much cheaper relative to the US, they are broadly in line with their long-term averages — except for China.

The ASX 200 was trading on a 12-month forward PE of 18x versus a long-term average of 14.7x.

“This combination of performance over recent months and high valuations implies lower returns than in 2024, with earnings the principal driver,” Mr Oppenheimer said.

Ahead of Friday’s US non-farm payrolls report, expected to show a 165,000 rise in jobs and 4.2 per cent jobless rate, he saw a “growing disconnect between stock performance and rate expectations”.

A 44 per cent rise in the S&P 500 since November 2023 came amid moderating inflation and the prospect of interest rate cuts — as well as the AI boom. However, Fed funds futures now imply US rate cuts totalling less than 40 basis points for 2025, down from 125 basis points in September.

“Perhaps more striking has been the rise in bond yields,” Mr Oppenheimer said.

The 10-year US Treasury yield has soared by about 1.1 percentage points to eight-month highs of around 4.7 per cent since mid-September. “Despite this, equity valuations have increased.”

Goldman Sachs’ bonds team argues these yields are starting to look stretched and bond yield curve steepening has now overshot its fair value estimate.

Nevertheless, rising equity prices, together with higher bond yields, have seen equity risk premiums fall further, leaving little cushion for equities markets in the event of bond yields rising further.

After comparing the most cyclic versus the most defensive parts of the market, Mr Oppenheimer concludes much of the strength in equities in recent months has reflected higher growth expectations, particularly in the US, where optimism on US deregulation and tax cuts have also played a role.

“This leaves equities vulnerable to any growth disappointments, particularly depending on specific policy measures by the incoming US administration in relation to tax and tariff decisions,” he said.

The vulnerability of US stocks to any disappointment with economic growth has been heightened by the increased concentration of equity market returns.

While the US market added 23 per cent in 2024, the Magnificent 7 soared 47 per cent versus 10 per cent for the median company.

Moreover, about 46 per cent of the S&P 500 return was generated by just five companies — Nvidia, Apple, Amazon, Alphabet and Broadcom — which added a massive $US6 trillion ($9.68 trillion) in market capitalisation, equivalent to the total size of the UK and German stock markets.

“Encouragingly, the dominance of the largest US technology companies has reflected powerful fundamental growth rather than irrational exuberance,” he said. “Over recent years the biggest US tech companies have far outstripped the rest of the US equity market in terms of earnings growth.”

Nevertheless, the extraordinary ramp-up in capex spending mega-cap technology companies are making is reducing free cash flow and the scale of future profit growth.

For example, while the Magnificent 7 is expected to generate earnings growth of 33 per cent in 2024, the rest of the S&P 500 is only expected to grow 3 per cent.

In 2025 and 2026 this gap is expected to narrow dramatically.

Mr Oppenheimer says Europe recently provided a lesson about the risks of high concentration.

The top 7 companies by market capitalisation fell in 2024 on the back of a series of earnings disappointments at LVMH, Novo Nordisk and ASML, which had a dampening impact on the broader market. It saw the gap in performance between the top 7 EU and US companies widen sharply.

“In our view, this makes the case for diversification more powerful,” Mr Oppenheimer said. “While we remain broadly positive on equities, the risks of near-term disappointment are rising.

“We continue to focus on diversification as a tool for improving risk-adjusted returns, and downside protection, which remains attractive given relatively low levels of volatility.”