Investing.com -- The premium investors are paying for high-quality U.S. stocks to decline as economic conditions normalize, Goldman Sachs (NYSE:GS) strategists said in a recent note.
The Wall Street giant highlights that the current premium for 'quality' stocks is at historically elevated levels, reflecting strong demand for companies with superior returns on capital, margins, and balance sheets. The widening gap in profitability across S&P 500 stocks has been a key driver of this valuation premium.
According to Goldman, that the current profitability gap, particularly the return on equity (ROE) gap between the highest and lowest ROE stocks, has reached a 45-percentage-point spread—nearly its widest point since the 1980s.
“Currently the long leg of our sector neutral returns factor, which sorts stocks on a blend of returns on capital, assets, and equity, trades at a 56% valuation premium to the short leg,” strategists said in a note.
“This premium currently ranks in the 97th percentile vs. history.”
However, Goldman believes these stretched premiums may begin to revert to historical norms, especially as economic growth remains robust and the Federal Reserve continues its monetary easing cycle.
“Paying elevated premiums for profitability and other ‘quality’ factors today appears at odds with a backdrop of strong GDP growth and the start of the Fed cutting cycle,” the note states.
Goldman also points out that slowing labor costs and lower interest rates will likely support ROE in the near term, reducing the need for investors to pay up for quality.
“Corporate borrow costs typically track changes in interest rates, albeit with a lag,” strategists explain. “Alongside the peak and subsequent decline of the 10Y UST yield since October 2023, borrow costs should also subside and become less of a headwind for ROE in the near term.”
Looking ahead, Goldman Sachs notes that the near-term performance of quality factors will be shaped by economic growth and interest rates.
In late 2023, quality factors underperformed as markets began to price in monetary easing, but rebounded in early 2024 with higher-than-expected inflation. These factors also performed well during August's volatility spike, though their momentum has slowed following the Fed’s first rate cut.
A strong jobs report could lead to a rotation away from expensive quality stocks into lower-quality, more affordable firms, as investors adjust expectations for labor market strength and future monetary policy.