How Much Further Will Stock Prices Fall?

Recession is coming.

That’s the growing consensus among economists and market prognosticators alike. It’s not hard to understand why they believe it. The yield curve, whose track record remains perfect in predicting economic downturns, has inverted to the greatest extent since before the financial crisis. Inflation is cutting into consumer spending and wrecking consumer confidence. Economic activity surveys are showing signs of slowdown, with Purchasing Managers Indexes at their weakest levels since the COVID recession. Housing activity has cratered under the weight of higher mortgage rates, and GDP printed 2 negative quarters earlier this year.

The global backdrop isn’t any better. War rages in Eastern Europe, and the continent faces an energy shortage brought on by deteriorating relations with Russia, one of the world’s largest energy producers. China continues to battle COVID with lockdowns of entire cities, crimping supply chains that are already under intense pressure.

And of course, central banks around the world are raising interest rates and pulling back on monetary stimulus in an attempt to bring down price inflation. The United States’ Federal Reserve has a poor track record when it comes to tightening monetary policy. The almost invariably go too far, pushing the economy into recession. And this time that seems to be their goal, as crushing demand and causing pain in the labor market seems the only solution to ever higher prices.

Recession is coming, but it isn’t here yet. Unemployment is near a 50-year low, retail sales are still healthy, and industrial production is higher than a year ago. The economy will surely get a lot worse if and when recession comes to pass.

But what does that mean for the stock market? The market is not the economy, and it never has been. The two are related, sure, but stock prices move based on human emotions and future expectations, not on how the world looks today. Stocks are, in fact, a leading indicator of economic activity. Is it possible that a recession is already fully baked into current prices? Perhaps.

We’re already 10 months into this bear market, and the S&P 500 has declined nearly 30% from peak to trough. The average bear market in the United States since 1940 has lasted about 18 months and featured a declined 33% – we’re already near the average magnitude of decline, but well short of the average length. Still, bear markets in the 60s and in 1987 took less time to develop to complete, as did the COVID selloff.

What’s unusual this time around is how early stocks peaked relative to the economy. Typically, stocks have peaked about 6 months in advance of the onset of a recession and bottom ahead of the economic recovery. Even if the recession were to begin in the first quarter of next year – ahead of most economists’ expectations – that would still be a full year after equity prices began their decline.

On that same note, if we believe stock prices bottomed in mid-October, we’d have to believe the timeline of the trough is just as unusual as the peak. We’d have to believe the recessionary bear market bottom is in before recession even starts! There’s no rule against this of course – there are no unbreakable rules in this game – but it would be highly unusual.

Among the largest risk factors in that scenario would be valuations. True, the forward P/E ratio of the S&P 500 has declined considerably from last year’s frothy levels. At 16x, we’re roughly in-line with long-term averages. But those forward earnings have yet to reflect the potentially catastrophic impact of a full-blown recession. For 2023, consensus still reflect bottom-line growth of 7% for the S&P 500 index. That’s on top of anticipated growth of 7% this year. Both rates are in-line with the long-term average, and in no way are they indicative of an imminent recession.

For context, operating earnings per share fell 22% during COVID, 57% during the financial crisis, and 32% in the aftermath of the dotcom bubble. If the US economy is headed for recession as most economists expect, analyst’s earnings estimates are woefully unprepared for the downturn.

If we think about how that might impact valuations, a COVID-like impact to the forward earnings estimate would put equity multiples at 20x. In a more extreme scenario like the financial crisis, the market would be priced at more than 30x forward earnings.

Current valuations may look reasonable, but only if everyone is wrong about the coming recessionary storm.

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