There is no recession. Despite all the doom and gloom from the economic pessimistas, the resilient U.S economy continues moving ahead quarter after quarter, year after year defying dire forecasts and delivering positive growth. These guys are going to wind up with egg on their faces.
— Larry Kudlow, in the National Review on December 7, 2007
That, right there, was not a great call.
In fact, that might very well have been the single worst call in the history of finance and it came courtesy of the man who is now advising Donald Trump on the economy.
Just to rub it in, here is a rather poignant visual which shows you just how bad Larry’s “egg on faces” call really was:
The good news in the current environment is that unless Larry writes another Op-Ed, a recession is probably not imminent. As we’ve explained on any number of occasions over the past several weeks, investors probably aren’t seeing what they think they’re seeing in the yield curve.
Of course we could end up with “egg on our faces” just like Larry, but hey, that’s fine. It wouldn’t be the first time.
In any event, recent price action is starting to make analysts’ 2019 S&P targets look pretty optimistic. Below is a snapshot:
That said, one thing you should note is that in mid-January of this year (when equities were in the midst of a pretty epic melt-up), pessimistic analysts’ 2018 year-end forecasts looked just as far-fetched as some of the more rosy upside calls look right now. And look where we are 11 months from January 2018 – Mike Wilson looks like a genius.
Anyway, you’ll note that Goldman’s year-end target is 3,000. That was delivered last month in their year-ahead U.S. equities piece which carried the following headline:
On Friday evening, the bank was out with a note that took a quick look at some of the client feedback to their outlook and in it, they remind you that their 2019 call has some fat tails.
“The baseline projection is the S&P 500 index climbs to 3000 at the end of next year, up 15% from the current level of 2600 [and] we assign a 50% likelihood to this outcome”, David Kostin writes, adding that the bank “estimates a 30% probability that the downside scenario is realized in which the S&P 500 falls to 2500 at year-end 2019 [and] the upside scenario [where the index climbs to 3,400] has a slightly lower 20% probability of occurring.”
Goldman is pretty confident in their earnings projections, but what they’re not so confident in is the outlook for multiples. “Our baseline forecast is the stock market trades at a forward P/E multiple of 16x at the end of next year, roughly 3% above the current level”, the bank says, before noting that their downside and upside market scenarios “assume year-end 2019 forward P/E multiples of 14x (-10% from today) and 18x (+15% from today), respectively.”
In short, this all depends on investor perceptions of the likely outlook for the U.S. economy or, more to the point, it depends on when investors start to price in a recession.
Hilariously, the answer to “When will investors start pricing in a recession?” appears to be “two months ago”. But assuming the current malaise reverses (i.e., assuming stocks don’t just keep on falling until Jerome Powell holds an ad hoc press conference in the Rose Garden where he cuts rates to zero and restarts QE while Donald Trump holds a hot poker to the back of his neck), there will presumably come a time when whatever bounce we get off current levels gives way to the “real” pre-recession trade. Here’s what Goldman has to say about that:
Scores of recent client meetings indicate that many investors believe the US economy will enter a recession in 2020. Given this expectation, a key source of investor concern stems from the fact that, since 1928, the S&P 500 index has fallen by more than 10% in 25% of the years before the start of a recession. P/E multiples typically peak 6-9 months before the start of a recession. Accordingly, if an economic downturn begins in mid-2020, then stock valuations would likely peak during 2H 2019 and gradually de-rate into the recession. Our downside scenario of 2500 reflects the possibility that investors begin to price a potential 2020 recession by the end of 2019.
That sucks. Is there any good news? Well, yes. The good news (however unrealistic it might seem right now), is that Goldman’s upside case for the S&P (which sees the index climbing an absurd 30% from current levels by the end of 2019) is at least partially predicated on history. To wit:
But the uncertainty around our 2019 equity outlook is not just to the downside. Rather than slowly cresting, equity returns are typically strong at the end of bull markets. Since 1930, equities have posted a median return of 35% during the last two years and 16% during the 12 months prior to reaching a pre-recession peak. In our 20% probability upside case where the index climbs by 30% and reaches 3400 at year-end 2019, economic growth remains strong for longer than investors expect, pushing the likelihood of recession further into the future. In such a scenario, the P/E multiple would re-rate to its early 2018 high of 18x. Since 1928, S&P 500 has returned more than 10% in 61% of years prior to a year with no recession.
So, who knows, right? Certainly not us.
But what we do know is that the chances of a recession in 2020 are seemingly pretty high, which means that by the time voters head to the polls to decide whether a certain “very stable genius” gets to preside over the economy for another four years, that economy will be mired in a downturn.