Goldman Sachs: As long as the U.S. economy does not go into recession, interest rate cuts will be beneficial for U.S. stocks

According to Goldman Sachs' latest analysis, the interest rate cut cycle initiated by the Federal Reserve will support the U.S. stock market, provided that the U.S. economy successfully avoids a recession.

According to news from the Wind Trading Desk, this week, the Federal Reserve implemented its first interest rate cut since December 2024, driving the S&P 500 index up 1% for the week and setting a new historical high for the 27th time this year. Goldman Sachs economists expect that the Federal Reserve will have two more 25 basis point rate cuts this year and two additional cuts in 2026, a path that is largely consistent with current market expectations.

As the market has largely digested the expectations of rate cuts, Goldman Sachs pointed out that the boosting effect of interest rates on valuations may weaken. This year, 55% of the total return of 14% for the S&P 500 index came from earnings growth, while 37% came from valuation expansion. Strategists expect that long-term interest rates will remain near current levels next year, with limited room for further significant declines unless the economic outlook worsens.

Goldman Sachs believes that corporate earnings will take over from interest rates as the core driving force behind future gains in U.S. stocks. At the same time, despite the stock market hitting new highs, investor positions are generally low, providing tactical upside potential for the market in a favorable macro environment.

Earnings Will Replace Valuations as the Main Driver of Stock Market Gains

David J. Kostin, Goldman Sachs' chief U.S. equity strategist, noted in a report that as the Federal Reserve's policy path is largely priced in by the market, the driving logic of the stock market is changing. They expect corporate earnings to continue to be the main driver of stock prices.

Data from the report shows that the forward price-to-earnings ratio of the S&P 500 index has risen from 21.5 times at the beginning of the year to the current 22.6 times. Goldman Sachs believes that although this valuation level is relatively high compared to historical standards, considering the current macroeconomic and corporate fundamental backdrop, its valuation is close to fair value.

Strategists judge that the accommodative Federal Reserve policy and the expected acceleration of economic growth in 2026 will support the market in maintaining its current valuation levels, allowing earnings growth to drive sustained returns in U.S. stocks. Goldman Sachs predicts that the earnings per share (EPS) of the S&P 500 index will grow by 7% in 2025 and 2026.

Historically, a rate cut cycle that avoids a recession is positive for the stock market. Goldman Sachs reviewed data from the past 40 years and found that in the eight cycles where the Federal Reserve started cutting rates after pausing rate hikes for more than six months, half ultimately fell into recession.

However, in the other four "non-recessionary rate cut" cycles where the economy continued to grow, the S&P 500 index achieved median returns of 8% and 15% within six and twelve months after the rate cuts, respectively. By sector, the information technology and consumer discretionary sectors performed best during these periods. In terms of investment style, high-growth stocks performed the best.

Low Investor Positions Provide Tactical Upside Potential

Despite the stock market being at historical highs, Goldman Sachs believes that low investor positions remain the strongest argument supporting short-term gains in the stock market. The firm's sentiment indicator currently reads -0.3, indicating that stock investors' positions are still "low." **

The report points out that among the nine components of the sentiment indicator, only one has deviated more than one standard deviation from its 12-month average. This relatively uncongested position suggests that if the macro backdrop remains stable and positive, there is still a significant amount of capital that could flow into the stock market, creating opportunities for "tactical upside."

Based on its market assessment, Goldman Sachs has adjusted its investment recommendations. Strategists continue to recommend holding companies with a high proportion of floating-rate debt. These companies can benefit from a tangible boost in earnings as short-term interest rates decline. It is estimated that for every 100 basis points decrease in debt costs, these companies' earnings will increase by more than 5%.

Meanwhile, Goldman Sachs warns that the recent strong performance of certain interest-sensitive stocks may weaken. For example, sectors such as residential builders and biotechnology have recently surged primarily due to the decline in long-term interest rates. Given that Goldman Sachs expects limited room for further declines in long-term interest rates, the growth momentum in these sectors may face a slowdown. Strategists believe that among interest-sensitive stocks, priority should be given to those categories that are also sensitive to economic growth prospects, such as small and mid-cap stocks.

In summary, the Goldman Sachs strategist team has updated its forecast for the S&P 500 index. They have raised their target levels for 3 months, 6 months, and 12 months to 6800 points, 7000 points, and 7200 points, respectively. This implies that from the current level, the index still has about an 8% upside potential over the next year.