Just a couple of days ago, Goldman Sachs (NYSE:GS) released a report projecting an annualized return between -1% and 7% for the cap-weighted S&P 500 index — this represents a projected average annualized return of 3% for the S&P 500. Here are the considerations behind these figures.
Valuation
The S&P 500 currently faces a cyclically adjusted PE (CAPE) ratio (also known as the Shiller PE ratio) of about 38. When we consolidate the CAPE ratio of the S&P 500 for the past 100 years, we find that the current metric of 38 times earnings sits at the 97th percentile. As such, it can be observed that the S&P 500 is trending such that the overall earnings of its constituents are not catching up with the valuation of the index.
Concentration
Another key fact is that the S&P 500 is more concentrated than ever, The top 10 stocks of the S&P 500 make up almost 40% of the index — a level of concentration that hasn't been seen for the past 100 years. Historically, market returns are often less attractive at higher degrees of concentration.
As such, Goldman Sachs has mainly used these two factors to come to its 3% prediction for the cap-weighted S&P 500 index. In addition, the report projects a 72% probability of bonds outperforming the S&P 500 in the next 10 years.
With all things considered, it may seem like Goldman Sachs is full-on bearish about the market — especially considering that for any 10-year period, the S&P 500 has only given an annual return of 3% or lower during major recessions. However, this is not necessarily the case.
Positioning Your Portfolio
While Goldman Sachs Chief US Equity Strategist David Kostin argues that he is not too optimistic on the cap-weighted S&P 500, he strong believes that the equal-weighted S&P 500 index has the potential to yield an 8% annual return over the next 10 years — which is 500 basis points greater than the predicted annual return of its cap-weighted counterpart.
This could very well be the case if we see significant valuation corrections in the top 10 stocks of the cap-weighted index, which comprises of the Mag-7 and also notable inclusions like Berkshire Hathaway (NYSE:BRKa) and Eli Lilly and Company (NYSE:LLY).
Given the current earnings yield of these companies (which are far from ideal), such a possibility cannot be ruled out. As such, investing in funds that track the equal-weighted S&P 500 index — like RSP ETF — may not be a bad idea. If you purchase individual stocks, adjusting the concentration of your holdings accordingly may also help position your portfolio for the next 10 years.
At the same time, Goldman Sachs is more bullish on the growth of mid-cap stocks, which typically have 25% or more of their balance sheet comprising of floating-rate debt. As such, with the Fed cutting rates, these companies benefit greatly from significantly reduced interest expenses and much more positive outlooks on future earnings. One can consider increasing exposure to such companies by investing in a fund that tracks the S&P Midcap 400 Index — a good example is IJH ETF.
Finally, investments in instruments with low correlation with the overall stock market are also good ways to hedge against equity market uncertainties. Think bonds, commodities and REITs — all of which may significantly outperform stocks during market downturns.
Regardless of experts' predictions, there will always be an element of uncertainty in equity markets, especially when we consider the upcoming elections and ongoing geopolitical tensions. As such, portfolio diversification is of paramount importance — and this can be achieved with sound investments in various asset classes.