### S&P 500 Recession Math

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How much recession risk is baked into the S&P 500 at current levels? Here is one way to think about that question:

• Start with current earnings power, which we know is \$54 – \$55/share per quarter since that’s what the index’s companies generated in Q4 2021 and Q1 2022.
• This works out to \$218/share, and that would be peak earnings (i.e., the S&P earned less in prior post-pandemic quarters) if we are heading into a recession.
• Recessions hit earnings, of course, but by varying amounts. Standard recessions (1990, 2000, 2020) cause an average 26 percent decline from peak to trough earnings. The 2007 – 2009 Great Recession saw S&P earnings decline by 57 percent from peak to trough.

Let’s assume the market is trying to price in a garden variety economic contraction, where S&P earnings go from \$218/share to \$161/share, that 26 percent drop that is the average of the 1990, 2000, and 2020 recessions. Here are the current valuations for the S&P 500 (at 4,000) based on a sliding scale of potential earnings:

• \$218/share (0 percent recession odds): 18.3x
• \$204/share (25 pct recession odds): 19.6x
• \$190/share (50 pct recession odds): 21.1x
• \$175/share (75 pct recession odds): 22.9x
• \$161/share (100 pct recession odds): 24.8x

To make sense of these PE ratios we need to know where the S&P 500 index has bottomed on a trough PE basis around prior recessions. Here is that data:

• October 1990: 15.3x
• October 2002: 20.0x (note: based on Q4 2001 earnings, that cycle’s trough)
• March 2009: 17.1x
• March 2020: 18.3x

The average of the last 3 observations is 18.5x, throwing out the 1990 reading because market valuations were generally much lower than now due to higher interest rates (10-year Treasuries at 8-9 pct). Obviously, 18.5x is a troubling result because it implies that even after a 16 percent YTD decline that the S&P 500 at 4,000 is still not putting any odds on a recession and the resultant decline in corporate earnings.

Takeaway (1): the S&P 500 needs to go to 3,525 (\$190/share trough EPS, 18.5x multiple) just to discount 50:50 odds of a recession. If we do actually get a typical economic downturn, then the S&P should trade for right around 3,000 (2,979, to be exact, at 18.5x \$161/share). We’d love to argue that the S&P should have a richer trough valuation due to its overweight in Tech, but the 2020 lows at 18.3x put a pin in that argument.

Takeaway (2): this is not a prediction, but rather a crude but historically defensible approach to assessing where the S&P “should” trade if recession fears continue to grow. If corporate America takes the Chair Powell’s hint (our prior point), a recession is not inevitable because the Fed could soften its outlook on rate policy. If the Russia-Ukraine war ends, oil prices would come down and lessen recession risk and inflation pressures.

Bottom line: as bleak as things look now, there are still pathways out of the mess markets find themselves in tonight. Recent volatility simply says investors think the window of opportunity to get back on the right track is closing. It is not shut yet; otherwise, the S&P would be at 3,500 (50:50 recession odds) or even lower.