Taking stock: Can the US rally continue?

Episode Summary

Executive Summary: Goldman Sachs strategist David Kostin says U.S. equities remain fairly valued despite a concentrated rally led by five AI-linked mega-cap stocks, which are supported by strong earnings and upward revisions. He raised his S&P 500 year-end target to 5,600, citing resilient earnings and slightly higher fair value multiples, while warning that AI payoff uncertainty, election volatility, and valuation risk could pressure markets ahead.

Main Topics: Market rally concentrated in five AI leaders (Priority: 5/5): Kostin explains that most of the S&P 500's 2024 gains have been driven by NVIDIA, Amazon, Microsoft, Alphabet, and Meta, whose performance reflects both AI enthusiasm and strong underlying fundamentals. Earnings strength vs. market breadth (Priority: 5/5): He argues the rally is not purely hype because the five leading names posted much stronger earnings growth and revisions than the rest of the market, though broad market stocks have lagged materially. AI investment and the question of monetization (Priority: 5/5): The podcast focuses on whether massive AI capex and R&D will translate into revenue and earnings gains, with Kostin noting investors are becoming more skeptical and will scrutinize second-half earnings reports. Valuation and interest-rate backdrop (Priority: 4/5): Kostin says the S&P 500 trades at a historically elevated multiple, but high margins and relatively lower real rates justify only a modest multiple compression by year-end. Fed policy and small-cap beneficiaries (Priority: 4/5): He expects lower short-term rates to help smaller-cap stocks more directly because of their floating-rate debt exposure, while longer-term Treasury yields matter more for overall market valuation. Election and tariff-related volatility (Priority: 4/5): Kostin expects volatility and possible downside into the U.S. election, followed by a post-election relief rally, while tariff concerns favor domestically oriented companies over internationally exposed ones. Positioning and sources of demand (Priority: 3/5): He notes the market may still have buyers because corporate buybacks and passive inflows can support mega-cap stocks, even as hedge funds are already heavily positioned in them.

Key Arguments: The year-to-date S&P 500 rally is highly concentrated: five AI-associated stocks drove most of the index's 15% gain, while the median stock rose only about 5%. The concentration is supported by fundamentals, not just speculation: those five firms grew first-quarter earnings 84% year over year versus about 5% for the rest of the market. Analyst revisions also favor the leaders: estimates for the five AI names rose 38%, while estimates for the rest of the market fell 5%. Investors are shifting from enthusiasm to scrutiny on AI, and the key test will be whether AI spending produces measurable revenue and earnings gains over the next 6-12 months. The S&P 500's valuation is elevated, but high margins and relatively lower real interest rates justify only modest multiple compression rather than a major derating. Lower Fed rates should help small caps most because about 30% of their borrowings are floating rate, reducing interest expense and lifting earnings estimates. Election uncertainty tends to weigh on equities before the vote and support them afterward once uncertainty is resolved; this year may be especially volatile because of close states and possible recounts. Tariff concerns make domestically oriented companies relatively more attractive than internationally exposed ones. Despite crowded positioning, buybacks and passive flows can still provide demand for large-cap U.S. equities. The main downside risk is that AI profits do not materialize as quickly or as strongly as investors currently expect, leading to multiple compression in AI leaders.

Data Points: S&P 500 year-to-date return: 15% - Kostin's framing of the market rally in 2024 Typical stock year-to-date return: 5% - Broad stock performance versus the capitalization-weighted index Five-stock share of rally: 60% - Five leading stocks accounted for most of the market's gains Five AI leaders' first-quarter earnings growth: 84% year over year - Earnings growth for NVIDIA, Amazon, Microsoft, Alphabet, and Meta Rest of market first-quarter earnings growth: About 5% - Earnings growth outside the five AI leaders Five leaders' earnings estimate revisions: +38% - Analyst expectations for the five leading AI names Rest of market earnings estimate revisions: -5% - Analyst expectations for the broader market outside the leaders AI-related CapEx and R&D share: About 22% of all U.S. CapEx and R&D dollars - Spending concentration among the five AI-focused companies S&P 500 forward P/E: Around 21x - Current valuation level discussed by Kostin S&P 500 forward P/E percentile vs history: 91st percentile - Historical valuation comparison 10-year U.S. Treasury yield: Around 4.25% - Longer-term rate used in valuation discussion Real 10-year Treasury yield: Around 2% - Inflation-adjusted rate backdrop S&P 500 implied year-end multiple: Around 20.5x - Kostin's expected fair value by year-end Previous fair value multiple assumption: Around 19.5x - Earlier valuation assumption before the upgrade S&P 500 year-end target: 5,600 - Kostin's upgraded forecast Previous S&P 500 year-end target: 5,200 - Prior forecast Expected market gain from current levels: About 2% - Approximate upside implied by the new target Expected 2025 earnings growth: Around 6% - Kostin's outlook for next year's earnings 12-month market forecast: 5,700 - Forward market level consistent with earnings trajectory Floating-rate borrowings among small caps: About 30% - Why small caps benefit more from Fed easing Expected corporate share repurchases: $934 billion - Largest source of U.S. equity demand cited

Pivotal Quotes: "five stocks have been responsible for 60% of the rally year to date" — Alison Nathan: Introduces the issue of market concentration and concentration risk "it's not hype. It's real fundamentals." — David Kostin: Kostin argues the rally in AI-linked mega caps is supported by earnings, not just enthusiasm "the central risk in the market is around the AI topic" — David Kostin: Identifies the most important downside risk for equities going forward

Implications: Investors should expect a market still supported by earnings, buybacks, and passive flows, but with limited upside and elevated volatility. AI monetization, election uncertainty, and valuation sensitivity are the key tests for the second half of 2024.