Investors Must Be Prepared For A Significant Global Downturn

Thesis

The market has shown investors how challenging it is to navigate one of the most demanding bear markets (for long-only investors) over the past ten years.

With the S&P 500 (SPX) down nearly 28% from its December 2021 highs, investors are demanding to know whether we are on the cusp of the next bull run, even though we could be approaching a global recession. We have often highlighted that the market is a forward-looking mechanism. Hence, it’s highly unlikely that the market had not priced in a recession ahead of time.

However, the critical question facing investors is whether the Fed’s aggressive rate hikes could trigger a severe recession than what the market is expecting now. Our analysis shows that Wall Street analysts are still in their “wonderland,” as their forward estimates suggest no recession in 2023. Yet, our valuation analysis (based on NYU’s Stern School of Business Professor Aswath Damodaran’s model) indicates that the market had already priced in a recession astutely.

However, we postulate that the market’s expectations suggest that its base case scenario anticipates a mild-to-moderate recession and not a severe downturn of the likes we saw in 2008/09 and 2020. However, the dynamics could change very quickly if the forward expectations worsen dramatically, resulting in much higher risk premiums, coupled with significant discounts to the consensus estimates appropriate for a severe recession.

While we are confident that the market remains positioned for a sustained rally from the current levels, we believe the risks of a severe recession have risen significantly. Therefore, we urge investors to revisit their battle plans to prepare for the possibility of a significant downturn even as they capitalize on the market pessimism to add more positions.

We Need To Be Prepared For A Fed That Could Trigger A Severe Recession

With the Fed unrelenting in its bid to combat inflation and inflation expectations decisively and rapidly, financial instability risks have risen sharply.

Bloomberg reported in a recent commentary indicating significant stress in the US treasury markets at levels not seen since the COVID pandemic. It also urged the Fed to intervene expeditiously to prevent an unforeseen unraveling that could have significant consequences. Bloomberg articulated:

The central bank can’t afford to let the world’s most important market seize up. It must act now to restore liquidity for Treasuries. A Bloomberg index shows liquidity in the Treasury market is worse now than during the early days of the pandemic and the lockdowns, when no one knew what to expect. Daily swings in interest-rate swaps have become extreme, proving further evidence of disappearing liquidity. Make no mistake, if the Treasury market seizes up, the global economy and financial system will have much bigger problems than elevated inflation. – Bloomberg

Hence, the recent mayhem that the Bank of England experienced could be manifesting under the hood. Furthermore, some developing countries are also “getting shut out of the bond market,” as the coordinated rapid rate hikes by the EU and the Fed have caused massive capital outflows that former Treasury Secretary Lawrence Summers accentuated:

There’s some fires burning, and the fire department is still mostly in the station. Finance ministry and central bank officials gathering in Washington don’t seem to be doing anything about the fact that many of these countries can’t even issue a bond today. – Bloomberg

Therefore, the risks of global financial instability triggering an unforeseen and severe worldwide recession can no longer be ruled out. Moreover, with the Fed steadfast in its bid to tame inflation expeditiously, the risks of a policy error overdoing its original intentions are rising. Even Edward Yardeni seems increasingly concerned, as he enunciated in a recent commentary (October 13): “It’s not often that the whole world’s economy faces a synchronized economic slowdown, but that’s what appears to be occurring.”

Consensus Estimates Need To Be Discounted Significantly

However, Wall Street analysts remain unperturbed by the global economic risks under the surface, as they still project earnings growth in 2023.

Accordingly, the revised estimates indicate that Street analysts still expect the S&P 500 to post earnings growth of 3.6% for Q4’22 and 7% for 2022. Moreover, they expect the market to post an earnings growth of 7.6% for 2023, suggesting an earnings reacceleration from Q3’22’s 1.6% YoY growth estimates.

Thankfully, the market’s positioning suggests that it has anticipated significant challenges for the US economy that could at least lead to a mild-to-moderate recession.

We used the revised forward earnings estimates for the S&P 500 and applied an expected forward equity risk premium of 4.7% (based on S&P Cap IQ’s latest data). Investors can debate whether the equity risk premium should be 5% or 6%, or even 7%. If they desire, they could adjust accordingly in their respective models.

We applied a -25% earnings surprise revision to the current consensus estimates to account for a deeper recession. However, it’s still below the mayhem in Q4’08 (-65% growth) and Q2’20 (-33% growth). Hence, investors must be prepared for more substantial value compression if the market anticipates a worse global recession.

Based on the model (with some revisions) provided by Prof Damodaran and using the parameters above, we derived a fair value estimate of about 3,102 for the SPX (down 11% from the current levels).

However, if we modeled a 35% decline to the consensus earnings estimates, the SPX’s fair value estimates could fall to 2,688 (down 25% from the current levels).

JPMorgan CEO’s Warning Is Not A Hyperbole

Therefore, investors could see that the market had anticipated a recession (albeit not a significant one) even though the Street analysts are still cheering for a reasonably good year in 2023.

However, investors must be prepared for more pain if the market expects the Fed’s hawkish stance to cause a significant financial event that could trigger a severe global downturn.

Hence, JPMorgan CEO Jamie Dimon’s recent warning about a further 20% slide in the market is not a hyperbole, as seen in our analysis. As a reminder for investors, he articulated:

It may have a ways to go. It could be another easy 20%. The next 20% will be a lot more painful than the first, rates going up another 100 basis points will be a lot more painful than the first 100, because people aren’t used to it. – Insider

So, while investors continue hoping for the best, they need to be prepared for worse outcomes. No one can accurately predict the market with absolute precision all the time (a timely reminder that past performance is also not indicative of future predictive potency).

As such, investors are urged to layer in over time appropriately. Also, don’t use leverage; allocate capital wisely, avoiding unnecessary concentration risks.