Goldman says upside to stock comeback is limited, downside risks loom

Goldman Sachs doesn’t anticipate much more of a comeback for stocks but does see downside risks ahead. The S & P 500 is up about 16% off its mid-June low and had already hit Goldman’s year-end target of 4300, before retreating. Now, however, the summer rally appears to be fizzling, with the index snapping its four-week advance last Friday and opening lower Monday . Goldman attributes the recent rally to the fact that investors embraced the view that the Federal Reserve will pivot from hiking rates seemingly at every meeting, and the economy will achieve a soft landing. In fact, while the market isn’t pricing in a final rate hike until February 2023 — six months from now —recent sector and factor performance have closely resembled the historical pattern around the end of the hiking cycle, David Kostin, Goldman’s head of U.S. equity strategy, said in a Friday note to clients. At the same time, the S & P 500 rebound also closely resembles a bear market rally , he added. “Performance around bear market rallies and the end of Fed hiking cycles look similar, and ultimately the path of both inflation and growth will determine the market’s trajectory through year-end,” Kostin wrote. For one, there’s a risk that the equity market could decline even after Fed rate hikes end. In 2000, the Fed’s pivot didn’t boost stocks going into a recession. “By contrast, if inflation surprises to the upside and requires the Fed to tighten more aggressively than our economists expect, we would expect equity valuations to compress as a result,” Kostin said. With the market trading hand-in-hand with real rates this year, lower real rates could boost stock valuations, according to Kostin. Positive earnings surprises could also provide some upside, although he thinks those are unlikely. Lastly, there’s room for upside if institutional investors, who are lightly positioned in stocks, add risk in a rising market, he said. Looming downside risks On the other hand, “Renewed fears about the prospect of a recession would almost surely unwind the recent rally,” Kostin wrote. Goldman economists estimate a one in three probability of a recession in the next 12 months. If that happens, the firm thinks the S & P could fall to 3150. In addition, the Fed’s focus on maintaining tight financial conditions requires that stocks don’t rise by too much, Kostin said. “As equity valuations climb, financial conditions loosen by definition,” he said. Goldman’s Financial Conditions Index (FCI) has fallen by 69 basis points from its June peak, meaning financing has become easier. “Equity valuation expansion has been the largest contributor to the loosening FCI during this period,” Kostin wrote. —CNBC’s Michael Bloom contributed reporting.