Can the Stock Market Continue to Rally?

The U.S. stock market has long been a barometer of economic optimism, but as Goldman Sachs revises its 2025 S&P 500 forecast to 6,500—a 9% price gain from current levels—the question looms: Can this rally endure? The answer hinges on a delicate interplay of valuation resilience, Federal Reserve rate-cut expectations, and sector rotation dynamics in a Trump-driven tariff environment.

Valuation Resilience: A Double-Edged Sword

Goldman Sachs' updated forecast hinges on a forward P/E ratio of 22x for the S&P 500, up from 20.4x, reflecting renewed confidence in large-cap stocks. This marks a stark contrast to the 17x valuation seen at the end of 2022. However, the S&P 500 now trades at the 93rd historical percentile for P/E ratios, a level that historically precedes significant corrections. While strong earnings growth (projected at 11% in 2025) and falling bond yields justify some optimism, investors must grapple with the reality that high valuations amplify downside risks. A single negative shock—be it a trade policy reversal or a slowdown in corporate earnings—could trigger a sharp reevaluation.

Fed Rate-Cut Expectations: A Tailwind or a Mirage?

The Federal Reserve's potential resumption of rate cuts is a critical catalyst. Goldman Sachs' macro valuation model suggests that every 50 basis-point decline in real bond yields could boost the S&P 500's forward P/E by 3%. With inflation cooling to 2.4% by year-end and the Fed signaling a dovish pivot, the stage appears set for a rate-cut cycle. Yet, the specter of fiscal dominance looms. The Trump administration's push for lower rates to reduce debt servicing costs risks undermining the Fed's independence, a precedent last seen during World War II. Investors must weigh whether the Fed will prioritize price stability or capitulate to political pressures, a choice that could reshape sector rotations and market breadth.

Sector Rotation: Winners and Losers in a Trump-Driven Tariff Environment

The Trump administration's recent tariff reductions—from 145% to 30% on Chinese goods—have recalibrated sector dynamics. Historically, Trump-era policies favored defense, industrials, and financials, while clean energy and global tech sectors faced headwinds. Today, the narrative is shifting. The S&P 493 (the rest of the S&P 500 excluding the Magnificent 7) is poised to outperform as domestic growth gains traction. Sectors like software and services, materials, and utilities are expected to benefit from AI monetization and infrastructure spending. Conversely, the Magnificent 7's outperformance margin is narrowing, with their 30 percentage point lead in 2024 projected to shrink to 6 percentage points in 2025.

Corporate earnings clarity is also reshaping rotations. The S&P 493's greater exposure to U.S. domestic demand positions it to capitalize on a steady GDP growth backdrop, while the Magnificent 7's international sales (nearly half of their revenue) remain vulnerable to trade policy shifts. This divergence underscores the importance of diversification.

Market Breadth and the Risk of a "Catch Down"

The current rally is driven by a narrow group of large-cap stocks, with the median S&P 500 stock trading 10% below its 52-week high. This imbalance raises the risk of a "catch down" if earnings expectations for market leaders weaken. However, Goldman Sachs notes that the S&P 493's earnings growth is expected to outpace the Magnificent 7 in 2025, suggesting a potential broadening of the rally. Investors should monitor breadth indicators, such as the number of stocks above their 200-day moving average, to gauge whether the rally is gaining momentum.

Investment Implications: Hedging the Risks

For investors, the path forward requires balancing optimism with caution. Goldman Sachs recommends a diversified portfolio overweight in sectors poised to benefit from AI monetization (software, materials) and those with exposure to floating-rate debt (which will gain from rate cuts). Defensive sectors like utilities and real estate also offer resilience. However, the high valuations of the S&P 500 necessitate hedging strategies, such as buying put options or allocating to mid-cap and international equities, which trade at discounts to their U.S. counterparts.

Conclusion: A Rally Built on Fragile Foundations

Goldman Sachs' revised forecast paints a cautiously optimistic picture, but the market's ability to sustain this rally depends on navigating three key risks:
1. Valuation Overhangs: The S&P 500's 93rd percentile P/E ratio demands robust earnings growth to justify its premium.
2. Trade Policy Uncertainty: A return to aggressive tariffs could disrupt supply chains and erode corporate margins.
3. Fed Independence: A shift toward fiscal dominance could reignite inflation, forcing the Fed into a reactive tightening cycle.

For now, the combination of rate cuts, earnings resilience, and a narrowing trade policy risk profile supports a continuation of the rally. Yet, as history shows, markets thrive on complacency and falter when complacency turns to hubris. Investors must remain vigilant, diversifying their portfolios and hedging against the inevitable shocks that lie ahead.