Markets Fairly Priced, Equities Only Place to Be: Goldman
The markets are fairly priced, and the single best trade right now is to sell bonds and buy stocks, especially dividend-payers and those with the most favorable risk-adjusted return profile, said David Kostin, chief U.S. equity strategist at Goldman Sachs.
"The outlook from now through December is likely to be a story of improving economic activity," he told "Squawk on the Street" Thursday. "I think that's a backdrop for improving earnings growth in the second half of the year for corporate America."
If this scenario plays out, Kostin expects a 6 percent increase for U.S. equity markets by the end of the year, with "high-single digit" growth annually through 2015. Over time, the market should be rising in line with growing corporate profits, he said, and predicted that the S&P 500 could hit 1750 by year-end.
He added that the trajectory for the macro economy is "all positive" over this period.
"The market is at a reasonable valuation," he said. "The No. 1 trade remains to sell bonds and to buy stocks because that economic scenario is a story of generally rising long-term rates. That's good for the earnings of many companies. It's basically a reflection of a better economy."
The fair valuation argument is based on several factors, Kostin said, including adjusted P/E ratios, a dividend discount model analysis, and the relationship between yields on stock earnings and bond metrics such as 10-year Treasury yields, TIPS and BBB Bond yields. "In all those metrics, equities are much more attractive than fixed-income securities," he said.
Major beneficiaries of this environment, which includes a stronger economy, include consumer discretionary and industrial companies, as well as financial firms in a steeper yield curve, Kostin said. On the other hand, consumer staples and health-care businesses have relatively high valuations and are less attractive right now.
A risk-adjusted strategy is a "particularly appropriate one," said Kostin, and suggested that investors compare a stock's price target to the six-month implied volatility.
Stocks with the best risk-adjusted returns include eBay, Qualcomm, Allstate and Wyndham Hotels, he said. "There are a variety of companies in different sectors that have attractive risk-adjusted return characteristics."
Another strategy in this environment is to focus on dividend-yielding stocks that are "likely to do very well," while investments in bonds have real potential to lose principal as yields are on the rise. He also recommends focusing on U.S. markets versus overseas or emerging ones, because the domestic market has lower implied volatility.
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Kostin said that from a valuation perspective, the Federal Reserve's plans to taper bond purchases had little effect on his expectations. "Although rates were rising, the relationship between bonds and stocks remained in the same conclusion that equities were much more attractively valued than bonds."
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The recent moves in commodity prices is a "moderation in prices" Kostin explained, and the overall economic picture will be a more dramatic driver for equities moving forward.