Is the US stock market going to undergo another "big rotation"? Goldman Sachs: Friday's non-farm payroll data is crucial!

Goldman Sachs strategists stated in a recent report that as the economic conditions normalize, the premium for high-quality U.S. stocks is decreasing.

The Wall Street giant emphasized that currently, the premium for "quality" stocks is at a historical high, reflecting strong demand in the market for companies with excellent performance in terms of capital return, profit margin, and balance sheet. The widening gap in profitability among companies in the S&P 500 index has been a key driving factor for this valuation premium.

Goldman Sachs stated that the current gap in profitability, especially the gap in Return on Equity (ROE) between stocks with the highest and lowest ROE, has reached 45 percentage points, close to the largest gap since the 1980s.

In a report, the strategist stated, "Currently, the valuation premium of the long side of our industry-neutral return factor (categorizing stocks based on capital return, asset return, and ROE) is 56%. Compared to history, this premium is currently at the 97th percentile."

However, Goldman Sachs believes that these excessively high premiums may start to revert to historical norms, especially in a scenario where economic growth remains strong and the Federal Reserve continues its monetary easing cycle.

The report pointed out, "In the context of strong GDP growth and the beginning of a rate-cutting cycle by the Federal Reserve, paying excessive premiums for profitability and other 'quality' factors seems unreasonable."

Goldman Sachs also noted that a decrease in labor costs and interest rates may support ROE in the short term, reducing the demand from investors to pay a premium for quality.

The strategist explained, "Corporate borrowing costs usually lag behind changes in interest rates." With the 10-year U.S. Treasury yield peaking in October 2023 and subsequently falling, borrowing costs should also decrease and no longer pose a hindrance to ROE in the short term."

For this week, the Goldman Sachs analyst team led by David Kostin wrote that if the strong employment data released by the U.S. Department of Labor on Friday may prompt some investors to "lower their expectations of a significant weakening in the labor market," leading them to "shift funds from expensive 'quality' stocks to less popular low-quality companies."

Due to investors betting on the support of loose monetary policy, the U.S. economy has managed to avoid a recession, and the U.S. stock market has returned to historical highs. The non-farm payroll report is the focus of the market this week, with expectations that the report will show a healthy but slowing pace in the labor market.

Analysis from foreign media factors shows that the so-called quality strategy (investors targeting the most profitable stocks) is one of the top five performing strategies in the U.S. this year.

Michael Wilson of Morgan Stanley recently pointed out that the impact of the labor market on the stock market will be greater than the outlook for interest rates. This strategist reiterated in a report last Sunday that he prefers large-cap stocks and industries with higher quality.