Goldman Sachs flags 3 possible scenarios for stocks with the bull market in its 4th year

• The bull market in stocks is starting to broaden out.
• Goldman Sachs identified three possible scenarios for the market as laggards start to outperform.
• A valuation collapse, a surge in stock prices, and stronger earnings are on the bank's radar.

A three-pronged path lies ahead for the stock market this year, Goldman Sachs says.

In a note to clients at the end of last week, the bank said it had identified three possible paths ahead for stocks as the bull market enters its fourth year. Those possibilities are determined by how the rally in stocks looks like it's starting to broaden out — and there are a few styles the broadening could take from here, according to the bank's portfolio strategy team.

A broader market rally has been the talk on Wall Street over the last several months, with laggards like small caps and international stocks beginning to outperform.

So far this year, the equal-weighted S&P 500 has climbed 4%, compared to the broader index's 1% year-to-date increase, Goldman said.

"History demonstrates three potential paths to an extended period of equity market broadening," a team of strategists led by the bank's Ben Snider wrote.

Here are three ways Goldman thinks the broadening could play out.

"Catch down": The market's largest stocks see valuations tumble

The first is a "catch-down" scenario — a dot-com-like correction where valuations of the largest stocks plunge, Goldman said.

Strategists didn't have an estimate for how much valuations could contract, but said the decline could be similar to the one the tech sector saw in 2001, when the dot-com bubble burst and brought valuations for internet companies back to earth.

Strategists said they saw such a decline in mega-cap tech valuations today as unlikely. While investors have been increasingly concerned about high valuations in the AI sector, tech stocks are priced at a forward price-to-earnings ratio of around 27. Compared to the rest of the S&P 500, that reflects a premium that falls in the 24th percentile relative to tech-sector premiums over the last 10 years, per Goldman's analysis.

"Instead, we expect the elevated recent dispersion in mega-cap tech valuations and returns will persist," they wrote.

"Catch up'': The rest of the market sees a valuation surge

Another possibility is that the rest of the market sees a sharp increase in valuations.

That possibility is supported by how economic growth seems to be accelerating during the Fed's easing cycle, strategists suggested. Under those two conditions, valuations for the equal-weighted S&P 500 have historically climbed 10% to 15% over a 12-month period, Goldman said, citing its analysis of valuations dating back to 1980.

Still, a catch-up isn't Goldman's base-case scenario. The bank pointed to how the equal-weighted S&P 500 is priced at a price-to-earnings multiple of around 17, meaning valuations in the equal-weighted index are currently in the 95th percentile when compared to valuations since 1990, strategists said.

"A dramatic 'catch up' increase in valuations across the market also appears unlikely," Goldman said. "The current SPW P/E is already modestly above fair value implied by the macro backdrop."

A broader market rally is powered by earnings growth

This scenario might best be described as the best of both worlds compared to Goldman's "catch up" and "catch down" scenarios.

In this outcome, the equity rally continues to broaden out, led largely by strong corporate earnings growth. Specifically, earnings in the "average stock" will outperform relative to the market's largest stocks, strategists later added, comparing the situation to the earnings growth the market saw in 2021.

"Our forecast for economic acceleration in early 2026 points to the third scenario as the most likely near-term outcome, and we expect the recent broadening will continue," strategists wrote.

Wall Street is expecting the S&P 500 to post 15% annual earnings-per-share growth this year and for the equal-weighted index to post 10% earnings growth. That's the most aggressive growth rate expected for both indexes in recent memory.

"We believe the ultimate degree of equity market broadening will depend on the degree of earnings broadening," the bank added, though strategists said there could be a "limited runway" for the rally broadening out as economic growth slowed heading into the second half of the year.