A Goldman metric shows stocks extremely overvalued

Published Mon, Jul 18 201611:19 AM EDTUpdated Wed, Jul 20 20169:21 PM EDT

Extreme valuations in stocks should cause investors to think twice before chasing the rally at these levels, Goldman Sachs cautions. "S & P 500 stands at an all-time high and the median stock's P/E is at the 99th percentile relative to the past 40 years," Goldman's market strategist David Kostin wrote in a note to clients Friday. Last week, the S & P 500 set a new intraday all-time high, surpassing its previous peak reached in May 2015, with stocks up a whopping 15 percent in the past six months. More traditional valuation measures show extreme levels, too. The S & P 500 trades at a forward P/E of 17.6 times, ranking the current levels in the 89th percentile since 1976, according to analysis by the investment bank. Source: FactSet "These valuations are only justifiable because of the historically low interest-rate environment," Kostin added. However, when using the so-called Fed Model , which compares the market's earnings yield to the 10-year Treasury rate, stocks also look fairly valued, Goldman said. The gap of 4 percentage points between the market's earnings yield (5.7 percent) and the 10-year (1.58 percent) is about equal to the historical average, the report stated. Given factors such as political uncertainty, bleak earnings revisions, a deceleration in buybacks, "overly-dovish policy expectations" by the Fed, and high valuations, Goldman thinks stocks could drop 5 to 10 percent in the near term and then end the year about where it is today. "As inflation expectations climb, the risk exists that the Fed tightens sooner than the market expects and bond yields may also rise," Kostin warned. As such, he thinks investors need to assess the market through those lenses. "Investors who believe rates will remain low should buy 'bond proxy' sectors including Utilities and Telecom ," Goldman Sachs recommended. Each of those groups is up more than 20 percent this year as bond yields fell, leading investors to opt for high-yield dividend stocks. For investors who predict yields will rise, Kostin advises them to overweight financials and stocks most sensitive to a potential rate hike. Some of those names include Starwood Hotels , Stanley Black & Decker , Yum Brands and Comerica .

Traders work in the Goldman Sachs booth at the New York Stock Exchange

Scott Eells | Bloomberg | Getty Images

Extreme valuations in stocks should cause investors to think twice before chasing the rally at these levels, Goldman Sachs cautions.

"S&P 500 stands at an all-time high and the median stock's P/E is at the 99th percentile relative to the past 40 years," Goldman's market strategist David Kostin wrote in a note to clients Friday.

Last week, the set a new intraday all-time high, surpassing its previous peak reached in May 2015, with stocks up a whopping 15 percent in the past six months.

More traditional valuation measures show extreme levels, too. The S&P 500 trades at a forward P/E of 17.6 times, ranking the current levels in the 89th percentile since 1976, according to analysis by the investment bank.