Goldman Sachs believes that if the U.S. economy can avoid a recession, the Federal Reserve’s rate-cutting cycle will support the stock market. Future upside momentum in U.S. equities will transition from valuation expansion to earnings growth. Despite stocks being at elevated levels, investors remain underweight, providing tactical upside potential. Goldman Sachs has raised its 12-month target for the S&P 500 Index to 7,200 points, forecasting an approximate 8% upside potential.
According to Goldman Sachs’ latest analysis, the rate-cutting cycle initiated by the Federal Reserve will provide support to the U.S. stock market, provided that the U.S. economy successfully avoids a recession.
According to information from the Wind Trading Platform, this week, the Federal Reserve implemented its first rate cut since December 2024, driving the S&P 500 Index up by 1% for the week and setting its 27th record high of the year. Economists at Goldman Sachs projected in their latest research report that the Federal Reserve will implement two additional 25-basis-point rate cuts this year and another two cuts in 2026, a path largely consistent with current market expectations.
As markets have mostly priced in expectations for rate cuts, Goldman Sachs pointed out that the boost to valuations from lower interest rates may diminish. Of the S&P 500’s total return of 14% this year, earnings growth contributed 55%, while valuation expansion accounted for 37%. Strategists expect long-term interest rates to remain near current levels next year, with limited room for further significant declines unless the economic outlook deteriorates.
Goldman Sachs believes corporate earnings will replace interest rates as the core driver of future U.S. equity gains. Meanwhile, despite repeated new highs in the stock market, investor positioning remains relatively low, providing tactical upside potential in a macro-friendly environment.
Earnings Growth to Replace Valuation Expansion as Primary Driver of Stock Market Upside
In a report, David J. Kostin, Goldman Sachs’ chief U.S. equity strategist, noted that as the Federal Reserve’s policy trajectory has largely been priced into markets, the drivers of the stock market are shifting. They anticipate that corporate earnings will continue to be the primary driver of stock prices.
Report data shows that the forward price-to-earnings (P/E) ratio of the S&P 500 Index has risen from 21.5x at the beginning of the year to 22.6x currently. Goldman Sachs considers this valuation level to be relatively high historically but, given the current macroeconomic and corporate fundamentals, close to fair value.
Strategists believe that accommodative Federal Reserve policies and expected accelerated economic growth in 2026 will support markets in maintaining current valuation levels, allowing earnings growth to drive continued returns in U.S. equities. Goldman Sachs forecasts that earnings per share (EPS) for the S&P 500 will grow by 7% in both 2025 and 2026.
Historically, a rate-cutting cycle that avoids a recession is positive for equities. Goldman Sachs reviewed data from the past 40 years and found that among eight rate-cutting cycles initiated after the Federal Reserve paused rate hikes for more than six months, half ultimately led to recessions.
However, during the four cycles of ‘non-recessionary rate cuts’ when the economy continued to grow, the S&P 500 Index achieved median returns of 8% and 15% in the six and twelve months following the rate cuts. By sector, information technology and consumer discretionary sectors performed the best during these periods. In terms of investment style, high-growth stocks outperformed the most.
Low investor positioning provides tactical upside potential
Despite record highs in the stock market, Goldman Sachs believes that low investor positioning remains the strongest argument supporting short-term upside for equities. The firm’s Sentiment Indicator currently stands at -0.3, indicating that equity investors remain ‘underweight’.
The report notes that among the nine components of the sentiment indicator, only one deviates from its 12-month average by more than one standard deviation. This relatively uncrowded positioning implies that if the macroeconomic backdrop remains stable and favorable, significant capital could still flow into the stock market, creating ‘tactical upside’ opportunities.
Based on its market outlook, Goldman Sachs has adjusted its investment recommendations. Strategists continue to recommend companies with a high proportion of floating-rate debt, as these firms can benefit significantly from declining short-term interest rates. It is estimated that for every 100-basis-point decline in debt costs, earnings for these companies could increase by more than 5%.
Meanwhile, Goldman Sachs cautions that the recent strong performance of some interest-rate-sensitive stocks may weaken. For example, sectors such as homebuilders and biotechnology have benefited primarily from the decline in long-term interest rates. As Goldman Sachs expects limited further declines in long-term rates, the momentum of these sectors may fade. Strategists suggest prioritizing categories within interest-rate-sensitive stocks that are also sensitive to economic growth prospects, such as small- and mid-cap stocks.
Synthesizing the above analysis, Goldman Sachs’ strategist team has updated its forecast for the S&P 500 Index. They have raised their three-, six-, and twelve-month target levels to 6,800, 7,000, and 7,200 points, respectively. This implies an approximately 8% upside potential from current levels over the next year.
