For investors hoping rate cuts would push the market higher, Goldman Sachs said stocks can't really go anywhere from here.
After the S&P 500's nearly 19% gain this year, the benchmark index is now trading near its fair value relative to interest rates, profitability as well as price-to-book valuations, according to David Kostin, Goldman's chief U.S. equity strategist.
"The path forward for index return on equity is likely to be challenging, although lower interest rates and lower tax rates may provide support," Kostin said in a note to clients Friday. "We believe policy uncertainty and negative revisions to 2020 EPS forecasts will limit equity upside."
The S&P 500 hit new all-time highs and reached a milestone of 3,000 this month as Federal Reserve's officials signaled easier monetary policy to sustain the record-long economic expansion. Traders are pricing in at least a quarter-point cut at the Fed's July 30-31 policy meeting, according to the CME FedWatch Tool. But an earnings slowdown and political uncertainties are likely to put a cap on stocks' upside.
In this slower growth environment, Goldman is advising clients to buy stocks with the fastest expected return-on-equity growth. ROE is a measure of profitability that is calculated by dividing net income by shareholders' equity.
"We forecast flat S&P 500 margins through 2020, with risks tilted to the downside. ... Amid concerns about the growth and profitability outlook this year, investors have assigned a premium to companies able to expand ROE," Kostin said.
Goldman has a basket with 50 S&P 500 stocks that have the highest consensus estimates of ROE growth. It has outperformed the S&P 500 by 5 percentage points so far this year.
"The basket typically outperforms in weakening growth environments as investors assign a scarcity premium to firms that are able to expand ROE despite index-level headwinds," Kostin siad.