Goldman Sachs Predicts Decline in Premium for High-Quality US Stocks

Investing Insights: Quality Stock Premiums Expected to Decline

Recent analysis from Goldman Sachs reveals that the premium investors currently pay for high-quality U.S. stocks is likely to decrease as economic conditions stabilize.

The firm emphasizes that the premium associated with ‘quality’ stocks has reached historically high levels, indicating strong demand for companies that exhibit superior returns on capital, profit margins, and solid balance sheets. This valuation premium has been driven largely by an expanding profitability gap among S&P 500 companies.

Goldman’s research highlights that the disparity in profitability, particularly between the stocks with the highest and lowest return on equity (ROE), stands at a 45-percentage-point spread—nearing its widest margin since the 1980s.

The strategists noted, "Currently, the long leg of our sector-neutral returns factor, which categorizes stocks based on a combination of returns on capital, assets, and equity, is trading at a 56% valuation premium compared to the short leg.” They added that this premium is currently positioned in the 97th percentile relative to historical data.

Despite these elevated premiums, Goldman anticipates that they may revert to more typical levels, particularly as economic growth continues robustly and monetary easing measures are implemented by the Federal Reserve. The note suggests, “The high premiums now placed on profitability and other quality factors seem inconsistent with the backdrop of strong GDP growth and the commencement of the Fed’s rate-cutting cycle.”

Moreover, Goldman forecasts that slowing labor costs and decreasing interest rates are likely to bolster ROE in the near term, thereby reducing the incentive for investors to pay premium prices for quality stocks. "Corporate borrowing costs generally follow interest rate trends, albeit with a delay," the strategists explained. They believe that with the peak and subsequent drop in 10-year Treasury yields since October 2023, borrowing costs should also lessen, alleviating pressure on ROE.

Looking forward, Goldman Sachs indicates that the performance of quality factors in the short term will be significantly influenced by economic growth and interest rates.

In late 2023, quality factors showed weaker performance as markets began anticipating monetary easing. However, they rebounded in early 2024 in response to higher-than-expected inflation, and displayed resilience during August’s volatility spike, despite momentum slowing following the Fed’s initial rate cut.

A strong employment report could prompt a shift away from costly quality stocks toward lower-quality, more economically accessible firms as investors adjust their outlook on labor market stability and future monetary policy.