The price is not correct.
That’s the verdict from strategists at Morgan Stanley and Goldman Sachs, who warned at the start of a new week that the stock market wasn’t fully pricing in a recession. And that’s like US SPX stocks,
got off to a solid start as trading resumed after the June 19 holiday on Monday.
“With our view of lower multiples and earnings now more consensual, the markets are more fairly priced. However, it doesn’t price in the risk of a recession, in our view, which is 15-20% lower, or about 3,000,” said Mike Wilson, chief U.S. equity strategist at Morgan Stanley and one of the more bearish voices on Wall Street this year. , in a note on Tuesday. “The bear market will not end until the recession hits or the risk of one is extinguished.”
Wilson believes much of Wall Street continues to assume much higher P/E ratios for year-end S&P 500 price targets. His bank was “very much out of consensus” going into 2022 with a forecast of a more than 20% drop in valuations – they are now down 28% year-to-date. But Morgan Stanley MS,
analysts have continued to abandon their valuation call as bond yields rise, with the current P/E ratio of 15.3 incorporating an equity risk premium (ERP) of 330 basis points, too low in its opinion.
Wilson would like to see the ERP at 370 basis points, which would leave the S&P 500 P/E ratio falling to 14x, provided TMUBMUSD10Y bond yields,
and earnings estimates are stable. ERP represents the extra return investors expect from riskier stocks over risk-free bonds.
Echoing some of Wilson’s thoughts was Goldman Sachs chief global equity strategist Peter Oppenheimer, who sees the market price at the risk of a mild recession, rather than an average or deep contraction. He sees the current bear market as cyclical and based on the business cycle, according to Goldman Sachs GS,
research note Tuesday.
“Most bear markets end when economic conditions are still bad, but there is a sense that they are no longer deteriorating at the same rate,” Oppenheimer told clients in the note. “Even if yields ultimately don’t rise much higher, it seems likely that markets will at least price in the risk of them doing so before we can see a genuine recovery.”
U.S. financial conditions aren’t really that tight by historical standards, so rates need to rise further or markets need to reassess risk, which would serve as an adjustment anyway, he said.
The S&P 500 tends to lose a third of its value, on average, around a recession, according to RBC Capital Markets.
“The average drop has been 32%,” RBC analysts, led by chief US equity strategist Lori Calvasina, said in a note on Tuesday. “That kind of drop would take the S&P 500 to 3,262 this time.”
The median peak-to-trough decline for the S&P 500 around a recession is 27%, which would drag the S&P 500 down to 3,501, the note shows.
The US stock market was trading sharply higher around noon Tuesday, with the S&P 500 up 2.2% to around 3,757, according to data from FactSet, at last check. The index is down 21% this year according to Tuesday afternoon trading.
“Last week we were on the road talking to investors in two different regions of the United States,” the RBC analysts said. “Most had stopped debating whether a recession was coming and were thinking about when it would start, how long it would last, how deep it would be and the conditions on the other side.”
The meetings were primarily with “long-term institutional investors that we would consider longer-term and focused on fundamental share price,” according to its note.
Several of the investors told RBC they had already “cut the edges and stuck with higher quality names that they like for the long term”, the analysts said. “Several also told us they already had much higher than usual cash balances.”