© Provided by Business Insider David Kostin is the chief US equity strategist at Goldman Sachs. Goldman Sachs

  • Goldman Sachs’ chief US stock strategist says the S&P 500 will reach 5,100 by the end of 2022.
  • Although stocks are at high valuations, David Kostin says investors don’t need to get too defensive.
  • He lays out how they can react to sustained growth, rising costs, and interest rates.

If there’s one thing investors want to hear about how stocks are going to perform in 2022, it’s that big returns this year don’t rule out the possibility of strong returns in the new year.

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“Counter to the intuition of many investors, the stellar 26% YTD return is not a good reason in itself to expect a weak return in 2022,” Goldman Sachs Chief US Equity Strategist David Kostin wrote in a note to clients. He notes that historically, one-year periods of 20% returns tend to be followed by better-than-average performance.

Kostin expects the S&P 500 to rise 9% to 5,100 in 2022, which would deliver a 10% return including dividends. Including the effects of higher real interest rates, that’s just a bit lower than its long-term average.

He adds that a mix of faster economic growth and lower-than-expected inflation could get the benchmark stock index to 5,500 at year-end, while more inflation and less growth could chop it down 25%, to 3,500.

Kostin writes that much of the market’s gains in 2021 came from valuation expansion, meaning investors were willing to pay more money for a consistent amount of profit or revenue. That probably won’t happen in 2022 because interest rates will rise.

“The historical experience during Fed tightening cycles suggests further valuation expansion is unlikely,” Kostin said. He has three big ideas for approaching this market.

(1) Post-pandemic, pro-inflation plays

“Own cyclicals, including “re-opening” stocks and those exposed to recent input cost headwinds that will benefit from accelerating economic growth in early 2022,” Kostin advises.

By way of example, he says that consumer goods makers, chemicals companies, and companies with supply chains that are exposed to China have all been beating the market recently because shipping costs and oil prices have stopped rising and “stalled.”

“These dynamics should continue as investors gain conviction that the worst of these headwinds have passed,” he wrote. “This cyclical tailwind is one reason we are assigning an overweight allocation to the financials sector.”

(2) Paying the cost — if you’re the boss

Wage growth hasn’t been this strong in decades, Kostin says, but it’s going to stay strong going forward. So he’s warning investors to stay away from companies that are vulnerable to the rising cost of labor.

“Our economists expect strong demand for workers and limited supply will keep wage growth elevated at a pace above 4% in coming years,” he said. That’s not a huge problem for most large-cap companies, but there are a few notable exceptions.

“Low labor cost stocks in the Leisure & Hospitality industry have outperformed high labor cost peers for most of this year,” he said. “A basket of stocks with high labor costs relative to EBIT has lagged the S&P 500 during the last few months, just as it did when wage growth reached a pace above 3% in 2018 and 2019.”

(3) Growth stocks that make money

Kostin maintained an “Overweight” recommendation on tech stocks, but says that rising interest rates will draw a sharp line between companies that are booking profits and those that aren’t. He writes that the profitable companies are in better shape for the long term.

“Stocks with “quality” attributes such as high returns on capital, strong balance sheets, and stable earnings growth have typically outperformed in similar past environments,” he said. “Growth stocks with elevated current profitability have comparatively shorter durations, and therefore less vulnerability to rising interest rates.”

Those companies are also more vulnerable to sell-offs after they disappoint Wall Street, he said, because investors are making big bets on their future, and they may dramatically recalibrate their expectations based on short-term developments.

Basic allocations

Kostin also upgraded healthcare stocks to “Overweight” in addition to his bank upgrade and his optimism about tech. He said healthcare should rally as the latest round of reform-related risk fades.

“Healthcare trades at depressed valuations that should recover as political risk eases,” he said. “It is a rare sector that typically outperforms in environments when real rates drive nominal rates higher, which describes our economists’ forecasts for most of 2022.”

On the opposite side, he assigns “Underweight” ratings to automobiles and auto components companies because they’re expensive, and says investors should minimize exposure to a group of companies that will struggle under these economic conditions.

“Our economists’ forecast for strong 4.0%+ annualized US GDP growth during the first half of 2022 suggests it is too early for investors to fully rotate into defensive sectors,” he said. “Consumer Staples, Utilities, and Telecom Services generally struggle to outperform the index as interest rates climb.”

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