The most important macroeconomic question facing investors today is “Can the Federal Reserve tame inflation without causing a recession?” As much as US stock prices are down this year, they do not reflect ANY recession risk.
Here’s how we know that stock prices do not discount a recession:
- At 3,900, the S&P 500 is trading for 17x expected 12-month future earnings of $229/share. This is the average forward multiple over the last 10 years, and fair given 10-year Treasury yields of 3 percent.
- Over the last 4 quarters the S&P has earned $216/share.
- Corporate earnings NEVER grow during a recession. In mild recessions they have averaged a 25 percent decline. In a harsh downturn, they can drop by 50 percent.
- Current market expectations of $229/share are therefore not consistent with a recession over the next 12 – 18 months since they are higher than the current S&P run rate of $216/share.
The historical relationship between both wage and price inflation and recessions is clear: the only thing that reduces inflation once it is at current levels is an economic downturn. The chart below shows US wage inflation (black line), Consumer Price Index inflation (red line) and periods of recession (gray bars) from 1965 to the present. We have also noted current wage and CPI inflation of +6.5 and +8.5 on the rightmost part of the graph to show the current elevated levels for each. The only precedent for current wage/price inflation is the 1970s/early 1980s.
Each arrow on this graph starts during a gray-barred recession (7 in all since 1965, excluding the very brief Pandemic Recession) and points to the subsequent decline in CPI inflation (red line) in the 1-2 years after the downturn. Recessions always reduce inflation. Given how high wage and price inflation is at present, it seems difficult to believe that they can decline back to reasonable levels without an economic downturn. How severe that recession must be to reduce inflation is unclear, but not the fact that a contraction is a historical precondition for lower inflation once it is as high as it is today.
Returning to our first topic – corporate earnings and S&P 500 price levels – we can make some simple assumptions about the former during a recession to estimate where US stocks might bottom should we start to see more signs that the US economy is tipping into contraction:
- We know current S&P earnings power is $216/share, since that is what the index has earned the last 4 quarters.
- Let’s assume a “typical” recession, where earnings decline by 25 percent. That puts recessionary earnings power at $162/share. This is what the S&P earned in 2018 – 2019 at the peak of the last economic/market cycle.
- Since recessionary earnings are the same as in 2018 – 2019, one way to estimate where the S&P 500 may make a low is to simply look at where the index traded at the end of 2019. That was 3,231.
- Another approach would be to assume that investors would pay more for trough (recession) earnings than the long run average of 17x. If we use a 19x multiple on $162/share, we get an S&P price target of 3,078.
Bottom line: stocks don’t actually care about recessions – they care about where corporate earnings go in a downturn, just as they trade on rising earnings expectations in an economic expansion. 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. US economic history strongly suggests that we will need a downturn to reduce inflation back to the Federal Reserve’s long-term 2 percent target. Connect these two ideas, and we believe it is prudent to wait for lower equity prices before adding stocks to a diversified portfolio.