Goldman Sachs: U.S. stocks are showing a "strong index, weak confidence" pattern, and a catch-up rally may become the main theme of the next phase.

Goldman Sachs: U.S. stocks are showing a "strong index, weak confidence" pattern, and a catch-up rally may become the main theme of the next phase. Goldman Sachs says the U.S. stock market is currently displaying an unusual setupstrong index performance but weak investor confidencewhich means the market still has room to rise further, and stocks that were previously left behind by AI leaders may be poised for a catch-up rally. The S&P 500 has gained 14% this year, but Goldman Sachs' U.S. equity sentiment indicator has fallen to -0.9, matching its March low. The gauge combines nine measures of positioning across institutions, retail investors, and foreign investors. Goldman strategists Ben Snider and his team said in a Sept. 25 report that this reading means investors still have room to increase equity exposure if the macroeconomic environment improves. The weakness beneath the index surface is even more striking. The S&P 500 recently traded just 1% below its August record high, while the median constituent was 16% below its own 52-week high. Goldman's preferred market breadth measure has fallen to its lowest level since the dot-com era. For investors, this divergence could be significant if uncertainty over interest rates and economic growth fades. Goldman believes there is room both for the broader market to rise and for lagging stocks to rebound, though unusually narrow market breadth could also keep momentum trades volatile. Index rises, but valuations fall Despite higher share prices, overall market valuations have been digested. The S&P 500's forward price-to-earnings ratio has compressed to about 19x, roughly in line with its 10-year average. Consensus forward earnings growth expectations are far above the index's own gain, pushing valuations sharply lower than a year ago. Rising rates are one reason. Over the one-month period covered by the report, the 10-year U.S. Treasury real yield rose 53 basis points. Goldman says that pace of increase has crossed a threshold that historically has often been associated with weaker equity returns. Goldman estimates that the S&P 500's current 19x valuation multiple is about 10% below the level implied by its model based on rates, inflation, and corporate profitability. The strategists do not interpret this discount as evidence that earnings prospects are too pessimistic. Instead, they believe investors are questioning whether current unusually high profit levels can persist. AI spending boosts profits, but the boost may fade That skepticism is especially important because the AI investment boom is in full swing. Goldman estimates that hyperscalers' capital expenditures will reach $800 billion this year. That spending is translating into revenue and profits for semiconductor companies and other AI infrastructure suppliers. The firm estimates that hyperscaler capex contributed about half of the S&P 500's earnings growth this year. But that benefit may not persist at its current scale. As AI capex growth slows and depreciation costs rise, Goldman expects its contribution to S&P 500 earnings growth to diminish and eventually become a drag. The supply shortages that previously supported semiconductor margins will also gradually fade as a tailwind. This helps explain an apparent contradiction in the current market. Based on near-term earnings, equity valuations look reasonable; but when looking at profits over a longer horizon, valuations appear expensive. The cyclically adjusted P/E ratio based on 10-year earnings is near historical extremes, below the 1999-2000 peak but above 2021 levels. Free cash flow paints a less extreme picture. Goldman calculates that the free cash flow yield for U.S. equities is 3.3%, below the historical median of 4.4%, but comparable to levels seen in several other periods in recent decades. Profitability determines valuation divergence Corporate profitability has become unusually important in determining which parts of the market command premium valuations. Goldman finds that nearly all of the current variation in industry price-to-book multiples can be explained by differences in return on equity. The relationship between industry profitability and valuation is now one of the strongest in decades. The S&P 500's current ROE is about 24%. Goldman calculates that the current 19x forward P/E implies an ROE of close to 22%, suggesting the market has already priced in some decline in profitability from unusually high levels. The firm's analysis also suggests that the recent strength in value stocks may be harder to sustain. Goldman's industry-neutral long-short value factor has risen more than 25% since mid-2025. But valuation dispersion among individual stocks has already narrowed, while Goldman economists expect economic growth to remain stable and near trend. Historically, both conditions have been unfavorable for the value factor. Investors' pricing lens shifts to the longer term At the individual stock level, Goldman observes a notable change in how investors are pricing shares. The market is increasingly focused on long-term revenue growth. Investors are assigning an above-average valuation premium to expected sales growth three years out, while giving less weight than usual to one-year sales growth. This shift reflects that the market is no longer judging long-term value solely on short-term earnings. The AI investment cycle has temporarily lifted profits at some companies, but AI technology itself may also erode future earnings at others. The result is that the market is increasingly focused on a fundamental question: after current unusual conditions normalize, which companies can still keep growing? Goldman maintains an optimistic view on the S&P 500 Despite the risks above, Goldman remains broadly bullish on the market. The firm forecasts S&P 500 earnings per share of $375 in 2026 and $415 in 2027. Its year-end 2026 target for the S&P 500 is 8,000, about 4% above the report's baseline level. Its 12-month target is 8,700, implying about 13% upside. As a result, the investment backdrop is more nuanced than the index performance alone suggests. The S&P 500 has risen sharply, yet its valuation multiple has fallen. Investor positioning is light, market breadth is at historically narrow levels, and profitability remains unusually high. For investors, Goldman's analysis suggests the market's next phase may depend less on another round of valuation expansion and more on whether earnings can support valuations. If macroeconomic uncertainty declines, sidelined cash and depressed positioning could fuel a broader rally beyond the AI-driven market leaders. But persistently high rates or a sharper normalization in AI-driven profits could test whether the current 19x P/E is really as modest as it appears.