“We believe much of the optimistic scenario is already reflected in US equity prices today.”

So said Goldman analysts including Ryan Hammond and David Kostin. “The optimistic scenario” refers to the most stock-bullish outcome from a trio of hypothetical “paths” for equity valuations contingent on real yields.

As readers are surely aware, reals fell dramatically over the last several weeks. After breaching 2.50% in October, 10-year reals receded more than 50bps in a very compressed time frame, bolstering equity valuations in the process.

The decline in reals was in no small part attributable to rampant speculation around Fed cuts in 2024. Amid a run of soft data and a nod to the likelihood of insurance cuts from Chris Waller late last month, traders pulled forward the first Fed cut to May and priced the March meeting as a coin toss. For the full year, traders went from pricing 75bps of cuts to more than 125bps.

There’s a tight relationship between market pricing for rate cuts in 2024 and reals, and between reals and equity multiples. The S&P 500’s six-week rally was driven almost solely by multiple expansion. The index’s forward P/E rose from 17x to 19x, and is now only marginally lower than it was at the local highs, Hammond and Kostin wrote.

The key takeaway — the reason November was so fortuitous — is the combination of dovish rates outcomes and a still sturdy growth outlook. “Equity investors do not appear to have equated additional Fed easing to increased recession odds,” Goldman wrote.

As the simple figure above shows, the best possible combination is falling yields alongside growth optimism. In the post-pandemic era, the aggregate multiple expanded by 1.5% on average during weeks when reals retreated and the equity market priced an improving growth outlook.

If that seems too good to be true to you, you’re not wrong. Indeed, the whole point of Goldman’s analysis was to (gently) suggest that stocks might’ve priced in the best of all possible worlds or, more accurately, the best of the three worlds Goldman is prepared to posit.

Below, find the three scenarios referenced here at the outset, as expounded by Hammond and Kostin.

1. Real yields fall further because of lower inflation and dovish Fed policy: 20x P/E. In this scenario, inflation data cool by more than we expect and the Fed is inclined to cut by more than we expect. The growth environment remains resilient, but Fed cuts lead real yields to fall to 1.5%. Based on our valuation model, this scenario would lead to a 5% increase in the aggregate P/E multiple. Using current consensus NTM EPS of $245, this scenario would imply an S&P 500 level of 4800. At year-end 2024, using 2025 EPS halfway between consensus and our top-down estimate, this scenario would imply an S&P 500 level of 5125.
2. Real yields rise modestly due to resilient economic growth: 18x P/E. Our rates strategists believe markets are approaching the limits of what can plausibly be priced in terms of Fed cuts without attaching material odds of a recession in the near term. Our economists expect that, amid resilient economic growth and a gradual cooling of inflation, the Fed will remain on hold until 4Q 2024, compared with 130bps of Fed easing priced by markets. In this scenario, we assume the real 10-year US Treasury yield rises to 2.3% at year-end 2024. Using current consensus NTM EPS, this scenario would imply an S&P 500 level of 4500. At year-end 2024, using a blended 2025 EPS estimate, this scenario would imply an S&P 500 level of 4700.
3. Real yields fall further because of economic growth concerns: 17x P/E. In this scenario, we assume that economic data are weaker than expected, leading to a slowdown in economic growth and an increase in the unemployment rate. We assume the Fed would respond with insurance cuts, contributing to a decline in real yields to roughly 1.5%. Based on our model, the weakening macro outlook would more than offset the lower discount rate for equities, leading to a 9% contraction in the aggregate P/E multiple. Using current consensus NTM EPS, this scenario would imply an S&P 500 level of 4150. At year-end 2024, using a blended 2025 EPS estimate, this scenario would imply an S&P 500 level of 4450. Earnings estimates would likely also fall, weighing on equity prices even more, but prices typically move faster than estimates.

Obviously, the first scenario is the most optimistic, and coming full circle, Goldman suspects it’s already in the price.

“Investors should consider using this entry point to buy downside protection,” the bank said, adding that with the aggregate forward index multiple now a mere 5% below Goldman’s optimistic outlook (versus 14% a month ago), multiples are “vulnerable to any macro shock.”

Fortunately, macro shocks are happening less and less often in the 2020s. (That’s sarcasm.)