GOLDMAN: One measure suggests stocks could crash 25%

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REUTERS/Vasily Fedosenko

A man takes part in an extreme run competition in Zhodino, east of Minsk, September 26, 2015.

The S&P 500 is looking a little pricey, according to Goldman Sachs' David Kostin.

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Kostin, Goldman's chief equity strategist, said in a note to clients that even though companies in the S&P 500 are becoming less and less profitable, they are not being penalized by investors.

"The historical relationship between return on equity (ROE) and price/book (P/B) shows investors penalize falling profitability with lower valuation," wrote Kostin. "However, despite the steady 200 bp decline in S&P 500 ROE to 14.1% during the past 8 quarters, P/B has actually expanded to 2.8x and is above the 40-year average of 2.5x."

ROE measures how much profit a firm generates for every $1 of shareholder equity. Thus, as ROE falls, this means that companies are making less per dollar of share value.

Additionally, price-to-book measures the value of a company similarly to price-to-earnings (P/E). Instead of measuring against profits, like P/E, P/B measures profit against all the assets that the company holds and could be sold if it were to liquidates, or its book value.

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Based on the current ROE of the aggregate S&P 500, according to Kostin, there is significant reason to believe there is some downside.

"Based on history, an index-level ROE of 14% implies a P/B of 2.1x, suggesting index downside of 25%," said Kostin. "Valuation of the median S&P 500 constituent is elevated relative to the aggregate index with a P/B of 3.1x and ROE of 16%."

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Goldman Sachs

Put another way, based on the historic correlation between ROE and P/B, the price side of price-to-book should likely fall to bring it more into line with historical trends.

Kostin has been warning about a possible pullback in equities for some time, as the market appears to be expensive compared to its historical average based on a number of metrics. This is another metric in that pullback narrative.

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The Goldman strategist has a year-end price target for the S&P 500 of 2100, it closed on Friday at $2139.16.

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