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A Goldman Sachs sign is seen on the floor of the New York Stock Exchange.BRENDAN McDERMID/Reuters

Stock market skeptics just gained a new ally: Goldman Sachs Group Inc.

Strategists there recommended investors temper their enthusiasm for U.S. stocks, arguing that last year's strong performance has raised valuations to the point where there's not much room for additional gains, but plenty of room for disappointment.

They cut their recommendation over the next three months to "underweight," forecasting that the benchmark S&P 500 will fall to about 1,800 within the first quarter and gain a mere 3 per cent for all of 2014, for a forecast that pales next to better opportunities abroad.

"After last year's strong performance, the U.S. market's high valuations and margins leave it with less room for performance than other markets, in our view," the strategists said in a note.

"Our U.S. strategists have also noted the risk of a 10 per cent drawdown in 2014 following a large and low volatility rally in 2013 that may create a more attractive entry point later this year."

The S&P 500 has gone more than two years without suffering a correction of at least 10 per cent, marking an unusually smooth ride that a number of observers believe is unsustainable – and the rough start to 2014 has added weight to their concerns.

David Kostin, chief U.S. equity strategist at Goldman Sachs, now pegs the odds of a correction this year at 67 per cent.

The index rose nearly 30 per cent last year, turning in its best annual gain since 1997. The gains coincided with improving economic growth, a recovering housing market and rising employment.

However, corporate earnings haven't been keeping pace with share-price gains, leading to stretched valuations. The S&P 500 now trades at about 16-times estimated earnings, compared with a historical average of 13-times earnings over the past 35 years.

Mr. Kostin pointed out that many of his clients believe the price-to-earnings ratio will continue to rise this year, perhaps to 17- or 20-times earnings, driving stocks higher as investors embrace the strengthening U.S. economy and ongoing low interest rates.

"Of course, it is possible," he said. "It is just not probable based on history."

He noted that since 1976, the S&P 500 has only exceeded a 17-times earnings multiple during the 1990s tech bubble and a four-month period in 2003-04. Outside the tech bubble, the S&P 500 has traded above the current valuation just 5 per cent of the time.

He argued that the yield on the 10-year U.S. Treasury bond could easily rise to 3.75 per cent by the end of the year, up from 3 per cent at the start of the year. That could act as a brake on rising valuations, since bonds will look more attractive relative to stocks. At the same time, he expects earnings will rise only modestly – by 7 per cent this year and 8 per cent next year.

As a result, he expects the S&P 500 will end the year at 1,900. But Goldman Sachs' new three-month target for the index is just 1,800, or about 20 points below its Monday close.

While that is by no means disastrous, Goldman Sachs sees better opportunities in Europe and Japan where they expect stocks will rise 10 per cent and 12 per cent, respectively. Japan has ongoing economic reforms going for it, along with rising corporate confidence and double-digit profit growth. Europe should see rebounding profit margins and a significant improvement in the economy.

As for the United States, economic improvements drove last year's stock market gains, making this year look like the start of a holding pattern, at best.

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