- US stocks fell straight into a bear market after the WHO declared COVID-19 a pandemic in March 2020.
- Cyclical sectors drove the S&P 500's return on equity lower, but it can rebound this year, GS says.
- The bank shares 33 stocks that have the highest expected ROE growth in 2021.
- See more stories on Insider's business page .
For more than one year, individuals, businesses, and financial markets have faced challenges brought about by the pandemic.
On March 11, 2020, the World Health Organization declared COVID-19 a pandemic, news that drove US stocks straight into a bear market . The Dow experienced its worst drop since 1987, and both the Nasdaq and S&P 500 closed more than 20% below their then-recent highs on March 12.
While some big-tech companies thrived in 2020, others in different sectors could barely keep afloat as their balance sheets deteriorated while virus cases rose and lockdowns were imposed.
Value and cyclical stocks were hit the hardest by the 2020 recession ; but it is precisely these companies that will likely see their fundamentals rebound this year as the economy recovers, according to David Kostin, Goldman Sachs' head of US equity strategy.
Industrials, energy, consumer discretionary, and financial stocks were the most heavily affected as their falling profitability drove the S&P 500's return on equity lower in 2020. ROE, a measure of profitability, for the index ended the year at 14.6%, the lowest level since 2016, Kostin wrote in a recent note to clients.
"Looking ahead, S&P 500 profitability should rebound in 2021, mostly driven by expanding profit margins," he said.
Strong GDP growth expectations are in part what's going to drive a rebound in these cyclicals, as these are linked with the economy, and a strong economic reactivation will benefit them in terms of return on equity. Goldman Sachs economists recently upgraded their US GDP forecasts to 7% for 2021, supporting Kostin's forecast that S&P 500 margins will increase to 11.2% this year, he added.
However, there are 3 risks that could threaten the prospect of higher profitability for the index.
The first one is that rising costs of factors of production could pressure profit margins, he said.
"The ability of companies to pass through rising input costs to consumers will be a key determinant of the trajectory of S&P 500 profit margins," according to Kostin.
Secondly, greater interest expense due to rising rates could negatively affect profitability, he added.
That's because a further rise in rates would increase interest expense, which means that when interest rates rise, banks charge more for loans made to businesses. In turn, higher loan payments could lead to a decrease in profitability.
And finally, tax hikes could adversely affect the S&P 500's return on equity, according to Kostin.
In fact, the second largest contributor to ROE expansion during the last 45 years has been declining effective tax rates which are the rates at which companies are taxed on their earned income, he said.
But as Biden calls for higher corporate taxes, his proposal could lower the S&P 500's earnings per share by 9% if fully enacted. However, Kostin and his team expect a smaller version to pass in the end.
"Our political economists expect a tax bill will be written later this year, meaning higher tax rates will not take effect until 2022," he added.
However, investors looking to take advantage of the rebound in S&P 500 profitability this year might want to consider the stocks in Goldman Sachs' ROE Growth basket. It has a value tilt and was recently updated with 33 stocks that have the highest expected return on equity growth.
The newly added names are listed below in no particular order. We have included their tickers, forward ROE, and ROE growth based on consensus estimates for the subsequent 12-month period.
Via PakApNews