The equity market is likely poised for a correction amid growing risks in the second half of 2024, Goldman Sachs (NYSE:GS) strategists said in a new note.
One of these risks is current elevated valuations in the market, which leave equities vulnerable to any shifts in fundamental factors. Although valuations are generally a poor predictor of near-term returns, they can amplify the impact of market moves if fundamentals start to change.
In particular, U.S. equity valuations have become stretched, with the market capitalization of the S&P 500 diverging significantly from other markets since the financial crisis.
“While this has reflected stronger fundamental profit growth, the current level of valuations implies such ‘exceptionalism’ is already expected to continue well into the future,” Goldman’s team said.
Moreover, while strong growth and earnings, particularly among the largest companies, have so far offset fading interest rate optimism, growth momentum has recently begun to slow.
The pace of US GDP growth has slowed from 4.1% in the second half of 2023 to an estimated 1.7% in the first half of 2024, while unemployment has risen from 3.5% to 3.8% on a three-month moving average basis. This period of weaker growth is expected to persist, Goldman notes, as real income growth has declined and consumer sentiment has softened.
“Election concerns in the US and Europe may also hit consumer and business confidence in coming months,” strategists pointed out.
In addition, the concentration of the equity market, especially in the technology sector and among the largest companies, also adds to correction concerns.
“While the prominence of the US equity market, of the technology sector, and of the largest companies does not reflect ‘irrational exuberance’, but a long period of superior fundamentals, it nonetheless raises the risks for investors,” strategists said.
Stock concentration in the S&P 500 is particularly extreme, with the top ten companies in the index now holding the highest weight in the index since 1929, Goldman highlighted.
Strategists also note that the combination of factors currently at play tends to correspond with inflection points in markets. The components of their Bull/Bear indicator, which includes factors such as the slope of the yield curve, high valuations, and low unemployment are all at high-risk levels.
This does not suggest an imminent bear market—thanks to the prospects of rate cuts and continued growth—”but it does offer a warning signal that a correction and period of higher volatility and lower returns is now more likely,” Goldman strategists concluded.