Despite being rather stubbornly bullish about the U.S. stock market and economy looking ahead to 2019, Goldman Sachs notes that the recent sharp selloff in the market offers some worrisome signals. "The S&P 500 appears to have priced a more substantial slowdown in growth than we expect," Goldman writes in the latest edition of their US Weekly Kickstart report. Goldman notes four big causes for concern, as summarized in the table below.

Red Flags From The S&P
Trailing 12-month return on S&P 500 points to lower ISM Manufacturing Index
Performance of cyclical vs. defensive stocks anticipates slower U.S. GDP growth
Recent stock declines suggest faster U.S. economic deceleration than Goldman expects
Soaring stock market volatility indicates high anxiety among investors
Source: Goldman Sachs

Significance For Investors

Goldman's base case calls for the S&P 500 to finish 2019 at a value of 3,000, up by 13.7% from the close on Dec. 10. Their upside case is 3,400, for a gain of 28.9%, while their downside case is 2,500, or a decline of 5.2%. These forecasts were presented in a recent edition of their Where to Invest Now report, entitled "2019 US Equity Outlook: The Return of Risk."

That report foresees a significant deceleration in annual EPS growth for the S&P 500, from 23% in 2018 to 6% in 2019 and 4% in 2020. Goldman is more conservative than consensus estimates, which are calling for 8% EPS growth in 2019 and 10% in 2020.

The Markets Speak
"The S&P 500 appears to have priced a more substantial slowdown in growth than we expect." -- Goldman Sachs

The decline in EPS that Goldman foresees is based on two additional forecasts that they are making. First, that sales growth drops from 10% in 2018 to 5% in 2019 and 4% in 2020. Second, that profit margins remain roughly stable at their 2018 value of approximately 11%.

Goldman's base case for the S&P 500 in 2019 rests on its forward P/E ratio remaining at its current level of about 16 times consensus earnings estimates over the following 12 months. The upside case assumes a return to the cycle high of 18 times earnings that was recorded earlier in 2018, along with downward revisions in earnings estimates for 2020 that are less than the historical average. The downside case envisions a contraction in the forward P/E to 14 times earnings, with deeper than average downward earnings revisions, which they say would be consistent with the normal pattern ahead of a recession.

A decidedly bearish outlook was voiced by Ed Clissold, chief U.S. strategist for Ned Davis Research Group. "Earnings growth is becoming a front-burner issue," he told CNBC, adding, "the slowdown is probably going to be more than expected." Noting that earnings revisions already are trending downwards, he said "that's going to continue to plague the market for a few more months."

Clissold believes that a bear market already is underway, which will bottom out sometime in early in the second quarter of 2019, given that "the average nonrecession bear lasts about seven months." A bear market decline of 20% from the all-time high of 2,940.91 on the S&P 500 reached on Sept. 21 would send the index down to 2,353.73, or 10.8% below the close on Dec. 10.

Looking Ahead

The level of anxiety that Goldman perceives in the market suggests that investors may be especially likely to overreact to bad news, creating an especially unstable investing environment. They note that the S&P 500 has had 57 daily moves of more than 1% so far this year, far more than the 8 recorded in 2017 and above the calendar year median of 49 since 2010.

Despite their expectation that the market will post gains in 2019, Goldman notes that their forecast boils down to "modest absolute returns" combined with "elevated risk." They continue, "If realized S&P 500 volatility matches the 30-year average, the risk-adjusted return in 2019 for the S&P 500 would equal 0.5, well below the long-term average of 1.1."

In general, Goldman advises investors to focus on "high quality" stocks with strong balance sheets, stable sales and earnings growth, and low historical propensity for big price declines.