Buy Netflix, Nvidia as higher rates stifle earnings

Akio Kon | Bloomberg | Getty Images

Reed Hastings, chief executive officer of Netflix, speaks during a news conference in Tokyo on Monday, June 27, 2016.

Goldman Sachs is encouraging clients to invest in high-growth stocks, predicting that higher interest rates in 2018 will cause earnings expansion to slow, therefore placing a premium value on fast-growing companies.

“The majority of the recent market rally has been driven by higher earnings rather than valuation expansion,” wrote Goldman Sachs chief U.S. equity strategist David Kostin. “Going forward, we expect growth to continue to drive S&P 500 stock returns. We expect that the prospect of 4 Fed rate hikes in 2018 will result in a forward P/E contraction.”

Kostin isolated firms allocating 90 percent of cash flow from operations to fund growth initiatives during the past three years into a “High Growth Investment” basket, including Netflix and chipmaker Nvidia.

To insulate the effects of reductions in earnings multiples, Kostin recommended these high growth stocks to investors.

Fifty-five percent of S&P 500 companies have beaten earnings expectations in the second quarter, the highest share of companies since 2010. Kostin reiterated that Goldman expects the S&P 500 will end 2017 at 2,400, slightly below its current level.

While information technology and health care have led the charge, investors have been slow to reward companies beating expectations with 2018 revisions, hinting at the market’s belief in future pressure on multiples in the market.