A big screen display of stock prices hangs behind traders working at the New York Stock Exchange NYSE on May 9, 2022.
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The S&P 500 is poised to fall another 29% if a typical recession hits the economy, according to DataTrek.The research firm said a 20% decline in corporate earnings would put the S&P 500’s annual EPS at $176.“It takes a lot of bad news to push S&P 500 multiples down to 15x, but this has happened 3 times in the last decade,” DataTrek said.
The going could get a lot tougher for investors if a typical recession materializes in the broader economy, according to DataTrek Research co-founder Nicholas Colas.
That’s because even after the S&P 500’s decline of as much as 28% this year, investors have yet to price in the potential for a significant drop in corporate earnings. And applying typical valuation multiples seen during recessions would drive the S&P 500 29% lower from current levels, he estimated.
“It takes a lot of bad news to push S&P 500 multiples down to 15x, but this has happened 3 times in the last decade,” Colas said, pointing to the Greek debt crisis in 2012, the Fed tightening tantrum in the fourth quarter of 2018, and the early stages of the pandemic crisis that saw the market hit lows in March 2020.
On top of the valuation decline, corporate earnings have fallen a minimum of 20% during all recessions since 1980.
With the S&P 500 on track to earn about $220 per share this year, a 20% decline would put annual S&P 500 earnings per share at about $176. And applying a 15x price-to-earnings ratio on that amount of earnings generates a price target of 2,640.
A decline to that level would represent a peak-to-trough decline of 45%, which is severe but not unheard of given the bear market crash during the Great Financial Crisis in 2008.
“The bottom line here is that multiple compression occurs when, at the margin, investors lose faith in either corporate earnings power or the predictability of Fed monetary policy. For all of this year’s disappointing equity market returns, neither is currently an outsized factor in setting daily stock prices,” Colas said.
All eyes have been on the Fed this year as it aggressively hikes interest rates to tame inflation, but that attention could shift if the broader economy takes a turn for the worse.
If a recession does materialize, then both valuations and S&P 500 earnings will move to front-and-center for investors and could ultimately lead to further pain in the stock market, even if the Fed lightens up on its interest rate hikes.