The discovery of the highly contagious COVID-19 variant omicron and concern that Federal Reserve policy will turn hawkish to fight inflationary pressures drove the 4% post-Thanksgiving S&P 500 decline, but the drop proved short lived as dip-buyers emerged, Goldman analysts including David Kostin said in the note.
"Given narrowing market breadth and growing macro risks, clients frequently ask us whether there is an elevated likelihood of a larger drawdown in the coming months," Kostin said in the note.
Apart from concerns such as virus spread continuing to undermine supply chains globally and that dynamic contributing to the build-up of inflation rates over the past several months, investors are assessing the potential impact of accelerated change in Fed policy rates on valuations.
Historical experience suggests equity valuations are typically flat around the first Fed hike, according to the note.
Moreover, some of the longest duration and highest valuation stocks slumped during the past month, implying equity market pricing of Fed tightening is under way. Among the steepest decliners in November included CrowdStrike (CRWD), Zoom Video Communications (ZOOM), and ARK Innovation exchange traded fund (ARKK).
"While 'unknown unknowns' cause the largest drawdowns and by their nature are impossible to assess in advance, the macro environment does not suggest drawdown risk is elevated in the coming months," Kostin said.
While US nominal and real rates are expected to rise, they remain low by historical standards over the coming months, supporting the backdrop for valuations and equity demand, according to Goldman. The analysts said the risk of a recession "appears low" and earnings and margins continue to surpass the market's expectations given the recent quarterly results.
"Despite narrowing [market] breadth, major drawdown risk during coming months appears limited due to light positioning, strong earnings growth, and share prices already reflecting likely Fed tightening," Kostin added.
Ranked by consensus 2023 profit margin, Goldman's top five stock picks which offer high margin and high growth are Mastercard (MA), MP Materials (MP), United Therapeutics (UTHR), Aspen Technology (AZPN), and Universal Display (OLED). Of these, shares of Mastercard and Universal are down year-to-date.
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