To stock investors who think a 20% bear-market-induced sell-off has discounted a recession, think again. Top market gurus from Morgan Stanley’s Mike Wilson to DataTrek’s Nick Colas are warning that the S & P 500 could drop another 20% from here if an economic downturn ensues like many indicators suggest. “At current prices, it seems extremely unlikely that stocks reflect the most likely scenario for future corporate earnings should we see a typical economic recession,” Colas said in a recent note. It has already been a painful 2022 with the S & P 500 suffering its worst first half since 1970. Sentiment was soured by fears that the Federal Reserve will hike interest rates aggressively to tame inflation at the cost of the economy. Meanwhile, Russia’s war on Ukraine and China’s Covid resurgence have only added to the volatility. Talk of a recession has grown louder and louder lately in the meantime. The widely watched Atlanta Fed GDPNow tracker showed an expected Q2 decline of 1.2% on July 8. Combined with the decline of 1.6% in the first quarter, a recession, which is generally defined as two straight quarterly declines in GDP, could be declared. Goldman Sachs this week slashed its GDP forecast for the second quarter to just barely above water. Wells Fargo economists said they expect more aggressive Fed policy to step up the timeline for a “moderate” recession starting soon and lasting a year. At the same time, the Treasury yield curve sent another warning this week that the economy may be falling or has already fallen into recession. The curve between the 10-year Treasury yield and the 2-year yield has become inverted, a phenomenon that has been a reliable recession indicator. Bank of America’s chief investment strategist Michael Hartnett believes the bear market has more room to go amid aggressive tightening measures. “It ain’t over ’til the Fed lady sings: bear markets end with a recession or an event that causes Fed to reverse policy,” Hartnett said in a note. “We say bear market in summer hiatus, and bear ain’t over and Big Low has yet to be reached.” Earnings in trouble Even though equity markets tend to be forward-looking, many argue that a full-on recession hasn’t been priced into declining asset prices yet if you take into consideration how much earnings can tumble. Colas said where the market goes in a downturn boils down to how much corporate earnings contract. In mild recessions, there is an average 25% decline. In a harsh downturn, they can drop by 50%, according to the strategist. “Corporate earnings NEVER grow during a recession,” Colas said. He calculated that the S & P 500 could bottom in the range of 3,231 to 3,078 in a conservative estimate with a 25% earnings decline. The forecast would translate into a 17% to 21% decline from here. Credit Suisse’s strategists also crunched the numbers, saying that the average decline in forward earnings estimates in the last four recessions has been 22%. The Wall Street firm said a recession is “highly likely,” seeing the S & P 500 drop about 18% to 3,200. In such a scenario, Credit Suisse said industries like tobacco, energy and household products in the U.S. are attractive areas to hide out. Bear market bounce? The stock market has attempted a comeback recently on oversold conditions, but the rally turned out to be short-lived. The S & P 500 rallied nearly 6.5% in the week ended June 24, posting its first weekly advance since May. Morgan Stanley’s Wilson, who has been one of the biggest bears on Wall Street, said gains in the near term will not be sustainable due to downward earnings revisions. “We continue to believe any near term rally is nothing more than a bear market bounce with lower lows ahead,” Wilson said in a note. If an economic downturn arrives, the equity benchmark could fall toward 3,000, or off about 23% from Friday, Wilson said. He added that the S & P 500 could bottom in the range of 3,400 to 3,500 if the U.S. avoids a recession. Morgan Stanley has an overweight rating on sectors including utilities, health care and real estate.
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