U.S. stocks are facing a witches' brew of higher interest rates, pricier valuations and a narrow dispersion of returns—and they may not have much more room to run in 2015, Goldman Sachs' David Kostin said Tuesday.
A Federal Reserve rate hike in September, "would be a challenge for the market to move higher. In fact I'm anticipating the market stays around these levels for the balance of this year," Goldman's chief U.S. equity strategist told CNBC's "Squawk on the Street." (Tweet This)
Kostin believes the Fed will raise interest rates twice this year. The central bank has held its benchmark rates near zero since December 2008, fueling a rush to stocks as investors seek yield. The Fed is widely expected to raise rates in 25-basis-point increments.
"Historically speaking, when the Fed hikes, you have a P/E multiple contraction on average around 8 percent in the first 90 days," he said. "That would suggest if you were to look back in the industry, the market has a lower P/E multiple at the end of the year—around 16 times, as opposed to where we are now."
With stock multiples currently at 18 times forward earnings, portfolio managers can either be pickier in U.S. markets or look overseas for returns, Kostin said. At home, he pointed to companies selling domestically.
"The idea of higher rates would suggest you have interest rate differentials and a stronger dollar, so if you have U.S. companies selling domestically—Chipotle is an example, Discover Financial Services—most of their revenues are domestic, that would be a positive to focus on in that area," he said.
Investors should also consider companies for which risk-adjusted returns and volatility are at play, he said. Kostin also likes technology stocks, saying there is underlying demand for tech solutions as companies seek to combat high margins.
As for companies investing in stock buybacks, he said that may not be the best use of capital at a time when price-earnings ratios are at elevated levels. Instead he believes mergers are a more attractive way for companies to allocate capital, both domestically and internationally, while the dollar remains strong.
Kostin expects S&P 500 companies to return about $1 trillion of cash to investors this year, about $600 billion in the form of buybacks, and $400 billion in dividends. He acknowledged that corporate repurchases have been a significant driver of flows into the market.
"The issue is every company has a hierarchy of uses of their cash," he said. "I would suggest that in many cases, buying back and repurchasing your stock with a P/E multiple of 18 times is a questionable use of cash."
Stock prices are at the 98th percentile of historical valuations in 40 years, Kostin said. Meanwhile, mutual fund cash flowing into exchange-traded funds is narrowing and compressing returns, he added.