Everyone’s talking about a recession these days. But over the past two weeks, my team and I have gone on our biggest buying spree since the depths of the Covid-19 pandemic in March 2020.
Because our mathematical analysis suggests stocks are already priced for a recession. Indeed, the numbers suggest that even if a recession strikes in 2023 (which is very possible), stocks will rally big over the next 12 months.
That’s why we’re buying stocks today. Recession or no recession, stocks look poised to run higher into late 2023. And the stocks we’re buying today could rise more than 100% over that stretch.
Here’s a deeper look.
How Recessions Impact Earnings
There’s a lot of noise out there about why stocks may go lower or higher. But at the end of the day, only two things really drive stocks: Earnings and the multiple that investors are willing to pay for these earnings. Mathematically speaking, earnings (x) P/E Multiple (=) Stock Price.
Therefore, to understand how a recession might impact stock prices, we need to understand how a recession will impact earnings and multiples.
Let’s tackle earnings first.
Recessions always negatively impact earnings. But the magnitude of the impact varies widely. Our historical analysis indicates there are three types of earnings recessions:
- Shallow: EPS tends to drop about 10%.
- Moderate: EPS tends to drop about 20%.
- Severe: EPS tends to drop over 40%.
Our understanding of the current macroeconomic fundamentals, as well as the drivers of a potential recession in 2023, strongly suggest that a shallow recession is most likely. A moderate recession is somewhat likely, and a severe recession is very unlikely.
The S&P 500’s EPS is set to finish this year at $225. Therefore, a shallow recession would bring 2023 EPS to about $200, while a moderate one would push 2023 EPS down to $180.
The Impact on Multiples
Believe it or not, recessions tend to positively impact equity multiples.
That’s because a recession marks a period of prolonged economic contraction. In times like that, the Fed tends to cut interest rates. And investors usually flock into risk-free investments like the U.S. Treasury. As a result, Treasury yields fall during recessions. Equity multiples are inversely correlated to Treasury yields. So, as yields fall, equity multiples tend to rise.
Specifically, every time the S&P 500’s EPS drops during a recession, the S&P 500’s P/E multiple tends to pop into the 23X to 30X range. This happened in the late 1980s, early 1990s, early 2000s, 2008/09, and 2020.
We don’t see any reason this time would prove different.
On the conservative side, then, the S&P 500’s P/E multiple should rise to 23X in 2023 in the event a recession hits and earnings drop. In a shallow recession, a 23X multiple on $200 in EPS implies an S&P 500 price target of 4,600 – up about 25% from current levels. In a moderate recession, a 23X multiple on $180 in EPS implies an S&P 500 price target of 4,140 – up about 10% from current levels.
We conclude, then, that the stock market is fully priced for a shallow or a moderate recession. If either strike in 2023, stocks should still rally big next year.
The only risk here is if the 2023 recession is a deep one. In that scenario, stocks would fall further. But given the strength of the consumer, labor market, and enterprise balance sheets, we believe the odds of a deep drawdown 2023 are very low. Indeed, they’re low enough for us to say with high conviction that stocks will most likely rally big next year, even if a recession hits.
The Final Word on a Recession Rally
They say that the intelligent investor is someone who sells high to optimists and buys low from pessimists.
There are a lot of investors out there who are pessimists right now, calling for stocks to crash to zero. Be the intelligent investor, and buy from those pessimists. Then, in a year or two, when the stock market has rallied more than 50% from its lows, sell to those same investors as they become optimists once again.
That’s what we’re doing. Investor sentiment hit “peak fear” over the past two weeks. We’ve been aggressively buying. Our new buys are rallying.
And we think this is just the start.
On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.