Market Extra: Here’s why Goldman says stock-market gains will be capped even as earnings rise

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Corporate earnings will rise and the economy will expand in the next few years, but the stock market will see only limited gains, according to analysts at Goldman Sachs.

In a Thursday note, strategists led by David Kostin raised their S&P 500 earnings estimate for each of the next three years, but left the price target for the index unchanged at 2,850 for year-end 2018 and 3,000 by the end of 2019.

The analysts said that “stock market price appreciation will be constrained by tightening monetary policy, a flattening yield curve, rising trade tensions and the upcoming midterm congressional elections.”

The S&P 500 SPX, +0.19%  has been unable to break out of its recent range, finishing with a loss of 0.6% on Thursday and down more than 4% from its all-time high set in late January.

When earnings grow faster than the share price rises, it results in what’s known as valuation compression, and that is exactly what Goldman Sachs expects over the next few years.

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“An environment of decelerating economic growth, a tightening Fed, a flattening yield curve, and political uncertainty is consistent with a [price-to-earnings] multiple that will end 2018 at 16.8x, unchanged versus today but 10% below its January peak,” they said in a note.

The analysts raised their earnings per share forecast for the S&P 500 in 2018 to $159 from $150, and lifted their 2019 EPS forecast to $170 from $158. For 2020, they lifted the forecast to $178, up from $163.

While the revisions are substantial, they are still below the even more optimistic consensus bottom-up forecasts. According to FactSet, analysts expect S&P 500 earnings per share of $161 in 2018 and $177 in 2019.

Yet, none of that seems to be enough to propel stocks to new highs, partly due to already high valuations and partly due to risks surrounding escalating trade tensions between the U.S. and its trading partners, and politics.

“The S&P 500 index currently trades at the 87th percentile of historical valuation relative to the past 40 years on a variety of metrics,” including forward P/E, enterprise value-to-sales, EV/Ebitda (earnings before interest, tax, depreciation and amortization), and price-to-book value. Stocks, however, trade at a slight discount versus history when valued relative to interest rates, the note said.

While U.S. equity investors were more than willing to pay high multiples for future earnings at the beginning of the year, that sentiment changed since the spike in volatility in February that accompanied a tumble that saw the S&P 500 lose more than 10%. The benchmark index has yet to fully recover from the correction.

Decelerating economic growth is yet another reason stock gains would be muted: U.S. gross domestic growth should decelerate after peaking at 2.9% in 2018, while profit margins will peak in 2019, Goldman said.

The trade battle with China so far would have a small impact on U.S. GDP growth, but further escalation could pose downside risk, the analysts said.

The environment will create winners and losers, with Goldman making a bullish call on growth stocks, particularly technology shares. Meanwhile, cyclical sectors, such as energy, materials and industrials are at risk.