Goldman sees two more bullish years

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If you're worried that record-high U.S. stock market indexes make equities look vulnerable to a sharp setback, Goldman Sachs suggests that you breathe easy: The investment bank believes the S&P 500 will rally for at least another two years, making today's levels look like a bargain.

The best part: The gains do not require a surge in corporate earnings, and even rising bond yields won't pose a threat.

David Kostin, Goldman's chief U.S. equity strategist, raised his target on the broad index to 1,750 by the end of 2013, up from his previous target of 1,625, implying a further gain of about 5 per cent from the current level. The S&P 500 has already risen about 17 per cent this year in a remarkably smooth rally that has astounded even bullish market watchers.

And Mr. Kostin thinks the good times have a lot longer to run. He believes the index will rise to 1,900 by the end of 2014, and 2,100 by the end of 2015. Those are significant increases to his earlier targets of 1,775 and 1,900, respectively.

If he's right, the bull market that began in March, 2009, will go on and on, and deliver gains of more than 200 per cent for the S&P 500, as marked from its multiyear low at the depths of the financial crisis.

Goldman's bullish view comes as many observers wonder what the stock market will do once the Federal Reserve signals that it is withdrawing the extraordinary stimulus measures it has used to prop up the U.S. economy in recent years.

The Fed has slashed its key interest rate to about zero per cent and it has been buying enormous quantities of Treasury bonds and mortgage-backed securities under a program called quantitative easing, arguably lowering unemployment, raising economic activity and boosting stock prices.

The concern is that without the Fed's assistance, stock values could retreat sharply – and the concern has taken on greater urgency with the U.S. jobless rate falling to a 41/2-year low of 7.5 per cent in April.

However, Goldman Sachs believes that the Fed will continue to provide economic stimulus because the falling unemployment rate has more to do with fewer Americans looking for work rather than with stronger hiring among employers. They estimate that the economy needs to generate another eight million jobs to return to normal.

As a result, they see the pace of quantitative easing slowing later this year, but nonetheless QE continuing until the third quarter of 2014. They don't see rate hikes until 2016.

"We believe equity markets will continue to perform well even if U.S. Treasury yields rise, provided the higher rates stem from improving economic growth prospects," Mr. Kostin said in a note.

Indeed, Goldman Sachs estimates the yield on the 10-year U.S. Treasury bond will rise to 3.75 per cent by the end of 2015, from just 1.95 per cent today.

But Mr. Kostin's bullishness is not just tied to the Fed. He argues that stocks will rise from a combination of bigger dividends and higher earnings multiples.

So far this year, about three-quarters of the S&P 500's gain has come from a rising price-to-earnings ratio, meaning that investors have been willing to pay more for each dollar of earnings.

Mr. Kostin expects the P/E ratio for the index, based on estimated earnings, will rise to 15 or 16, from 13.2 last year, marking a slight premium over fair-value estimates.

"Reasons for a higher multiple include increased confidence in the medium-term outlook for U.S. economic growth, improving investor risk appetite and the wide gap between equity and bond yields that we now assume will be closed more by stocks than bonds," he said in a note.

He also points to rising dividends as a key source of the ongoing rally, which is an interesting alternative view to the usual investor focus on corporate earnings.

In fact, Mr. Kostin has left his earnings estimates over the next few years unchanged, but now expects companies within the S&P 500 to raise their dividends more aggressively – by 30 per cent between 2013 and 2015, as companies distribute a greater proportion of their earnings as cash payouts.

Right now, the dividend payout ratio for the S&P 500 is just 33 per cent, near its lowest level in recent decades but headed higher: Even as earnings rose just 6 per cent in the first quarter, over last year, dividends rose 12 per cent.

The biggest boosts will come from technology stocks, financials and consumer discretionary stocks, which currently have the lowest payout ratios.

Mr. Kostin believes that the dividend yield on the S&P 500 will remain relatively stable at 2.2 per cent, implying that share prices will rise with dividends.