Goldman Sachs top trader: US stocks are still in a bull market, but the margin for error is quite small, and the risk/reward is not very attractive

Goldman Sachs' top trader and hedge fund research director Tony Pasquariello wrote a research report over the weekend reviewing the Federal Reserve's first rate cut in four years, stating that "the Fed rate cut cycle has officially begun."

He pointed out that in the past forty years, there have been five instances where an economic recession did not follow after a rate cut by the Fed. On average, the S&P 500 index rose by 17% in the 12 months following the first rate cut.

However, in the current rate cut cycle, the U.S. GDP growth remains strong at around 3%, with the Dow and S&P hitting historical highs. This has made the current stock market, especially the tech-heavy Nasdaq 100, "not very attractive in terms of risk/return," and with "very limited margin for error":

"The current P/E ratio of the S&P 500 is twice that of the average starting point of the five previous loose monetary policy cycles without a recession following.

Goldman Sachs expects the U.S. GDP growth to be 2.8% this year, decreasing to 2.3% in 2025, and further dropping to 2% in 2026. In the backdrop of an inevitable economic slowdown, with stock market valuations soaring, the limited margin for error will be a major factor determining market direction."

This top trader still believes that the U.S. stock market is in a bull market, with the future trend still upward. However, the risk/return has significantly decreased, with a "very stringent setup and an unstable path." Nonetheless, the strategy of buying during significant market pullbacks in the past two years remains effective.

Specifically looking at the Sharpe Ratio, which measures the ratio of excess return to risk taken, the research report found that from the low point in October last year to the historical high in July this year, the Sharpe Ratio of the Nasdaq 100 index was close to 4.4. This means that for every unit of risk taken relative to the risk-free rate, there would be a 4.4 unit excess return. The current Sharpe Ratio has dropped to -0.4:

"As pointed out by Dominic Wilson, Senior Advisor at Goldman Sachs Global Markets Research Group, the current period is similar to the transition period from the first half of 2014 to the end of 2014/early 2015, as well as some experiences in 1996.

The market environment we are in is still bullish, but in the next phase, the Sharpe Ratio measuring investment returns will be much lower. In this context, I believe that betting on a single stock/sector/theme in the market can yield the highest returns."

Following that, this top trader outlined several major themes he is focusing on:

1. Capital Flows

Fundamental hedge funds have been reducing risks for two consecutive months, while U.S. long funds were the main buyers around the time of the Fed rate cut. Given the restrictions on corporate stock buybacks next month, the most important thing is what U.S. households will do, and I believe they will buy U.S. stocks.

2. U.S. Tech Stocks

In the past four months, market participants have significantly reduced their bullish bets on technology stocks, but the performance of technology stocks continues to outperform the broader market. I believe the macro environment is favorable for technology stocks, with very good cash flow dynamics. When next month's corporate earnings report leads to a significant price pullback, one should buy in.

3. U.S. Consumers

The latest data on retail sales in the United States indicates that U.S. consumers will continue to resist the bear market. Now is the window of opportunity for non-essential stocks to outperform the broader market. At the same time, there is a general expectation that cyclical stocks will outperform defensive stocks.

4. Stock Indices Outside the U.S.

Taking a broader perspective, the Bank of Japan is moving against the tide of interest rate cuts by major central banks in Europe and the U.S., making Japanese assets seem to have formed a self-contained entity. This may suppress the inflow of foreign capital, and the issue of re-inflating inflation should not be ignored. So far this year, U.S. stocks have once again easily outperformed European stocks, with a total return twice that of the latter, seemingly contradicting market expectations at the beginning of the year.

In summary, this top Goldman Sachs trader is bullish on non-essential consumer goods stocks in the U.S. outperforming the broader market, and believes that U.S. tech stocks will regain their structural advantage over bonds and defensive stocks.

Earlier reports indicated that after the Federal Reserve made a significant 50 basis point rate cut last week, according to Goldman Sachs' main broker weekly report as of September 20th, hedge funds bought U.S. technology, media, and telecom stocks at the fastest pace in four months. Despite starting to increase their holdings of tech stocks and buying for the third consecutive week after weeks of selling, hedge funds' overall positions remain close to a five-year low.

Last Friday, Scott Rubner, a research fund flow expert at Goldman Sachs who accurately predicted the U.S. stock market pullback in late summer this year, forecasted the trend for the remaining three months of the year. He stated that there would be a bearish trend at the end of the third quarter, a drop before the U.S. presidential election in early November, and a rapid rise before the end of the year.