Large-scale disparity observed in S&P 500, as top-tier equities take the forefront, according to Goldman Sachs
High Valuation Gap in S&P 500 Favors Quality Stocks
In the current market, a significant valuation gap exists between "quality" stocks and lower-quality stocks in the Standard & Poor's 500 (S&P 500) index. According to Goldman Sachs Investment Research and FactSet, quality stocks, characterised by high profit margins and strong balance sheets, are trading at a 57% price-to-earnings (P/E) premium over their lower-quality counterparts, a figure that ranks in the 94th percentile since 1995.
This gap is primarily driven by high market dispersion and sector leadership, defensive investor positioning amid economic uncertainty, and a focus on specific themes. The S&P 500 has experienced historically high return dispersion, with the three-month return dispersion at the 82nd percentile over the past 30 years. Investors have favored high-quality stocks as a defensive strategy, with companies typically having strong profit margins, lower debt, and better resilience to economic shocks.
Investors have notably favored artificial intelligence, large-cap, and cyclical/industrial stocks, while avoiding defensives and small caps. This sector and factor bias contributes to the valuation divergence. Historically, when the quality factor valuation premium has been above 40%, the factor has never risen by more than 10% over the following 12 months.
Despite this, the forecast suggests that the economic slowdown and inflationary pressure is likely to continue favoring quality stocks. Goldman Sachs' economists anticipate below-trend growth and above-target inflation in the coming months. However, the investment bank also expects this inflationary pressure and economic slowdown to be temporary.
The table provided lists 25 S&P 500 stocks with strong balance sheets, high returns on capital, low volatility, and high margins. Notable stocks include NVIDIA Corp., Microsoft Corp., Apple Inc., Alphabet Inc., Procter & Gamble, Coca-Cola Co., Linde plc, Booking Holdings, Intuitive Surgical, Adobe Inc., ConocoPhillips, Altria Group Inc., Cintas Corp., Sherwin-Williams, Ecolab Inc., Illinois Tool Works, Colgate-Palmolive, Zoetis Inc., EOG Resources Inc., Fastenal Co., Paychex Inc., Copart Inc., ResMed Inc., Veralto Corp., Fox Corp., Packaging of America, and RMD Inc.
For investors uncertain about the near-term macroeconomic outlook, these stocks, driven by idiosyncratic factors, could offer more protection in an environment marked by uncertainty. Kostin suggests that investors should be cautious of a potential sharp rotation toward lower-quality stocks if economic and earnings growth proves more resilient than anticipated.
The return dispersion ranks above the 70th percentile across nine of the 11 sectors. The median stock in the S&P 500 is 12% below its 52-week peak. The list median market cap is $89 billion, the median 12-month return is 4%, the median NTM P/E is 24x, the median Altman Z-Score is 7, the median ROE is 31%, the median volatility is 23%, and the median margin is 25%. The S&P 500 median market cap is $37 billion, the S&P 500 median 12-month return is 4%, the S&P 500 median NTM P/E is 19x, the S&P 500 median Altman Z-Score is 4, the S&P 500 median ROE is 18%, the S&P 500 median volatility is 10%, and the S&P 500 median margin is 29%.
- The high valuation gap in the S&P 500, favoring quality stocks, could potentially impact technology stocks, as many quality stocks on the list provided, like Microsoft Corp. and Alphabet Inc., are technology companies.
- With the continuing economic slowdown and inflationary pressure, there might be increased focus on the health of a company's balance sheet and profit margins (a characteristic of quality stocks), potentially influencing investment decisions in the stock-market.
- As investors weigh the uncertain near-term macroeconomic outlook, they may choose to invest in environmentally-friendly companies with strong financials, such as NVIDIA Corp. (known for its work in AI and environmental-sustainable technologies), as a defensive strategy to mitigate risk in an uncertain market.
