Goldman Sachs downgraded its outlook on equities to neutral from overweight over the next three months, citing peaking growth momentum and tighter monetary policy from the Federal Reserve.
“The asymmetry for equities is turning increasingly negative,” Christian Mueller-Glissmann, an equity strategist at Goldman Sachs, said in a report. “This also means more vulnerability to potential shocks, e.g., from European politics, U.S. policy, commodities and China.”
The S&P 500
has gained more than 18% over the past 12 months while valuations—estimates of an asset’s worth—are nearing tech-bubble levels making equities more vulnerable to a sharp correction.
“High equity valuations alone are not a reason for drawdowns in the short term, if they reflect stable or improving macro conditions; but they indicate elevated drawdown risk,” he said.
His colleague David Kostin, chief U.S. strategist at Goldman Sachs, recently estimated that the S&P 500’s valuation rose to 18.1 times price-to-earnings per share ratio, the highest since 1976, excluding the dot.com bubble.
The large-cap index has also gone for more than a year without a 10% drawdown while volatility remains subdued, which in and of itself is not a cause for panic. However, market participants should remain on alert as volatility is a lagging indicator, Mueller-Glissmann said.
In November, Goldman Sachs had projected the S&P 500 to top out at 2,400 points in the first quarter and then close out 2017 at 2,300, a view it reiterated recently.
The downgrade aside, the analyst maintained his overweight rating on stocks for the next 12 months, predicting a 5% return. As such, investors should replace their equity positions with call options which give the holder the right to buy a stock at a specific price over a certain period.
Meanwhile, Mueller-Glissmann kept bonds at underweight on expectations for a higher interest rate environment globally and maintained commodities at overweight as fundamentals are likely to recover. He also maintained cash at overweight, given the rising odds of a stock market selloff.
“Cash has a very good track record since the ‘90s for keeping its real value during equity drawdowns,” he said.
The S&P 500 rose 0.8% to 2,385.26 while the Dow Jones Industrial Average climbed 0.5% to 10,950.10 after the Fed on Wednesday raised interest rates by 25 basis points and confirmed market expectations of two more hikes this year.