US Stocks Could Fall 40% In Worst Case, Deutsche Bank Says

If the current malaise on Wall Street is a non-recession correction, it’s an unusually long one.

“Corrections outside of recessions typically ended in three months,” Deutsche Bank’s Binky Chadha and Parag Thatte wrote, in an exhaustive, chart-heavy piece called “At The Recession Crossroads.”

May marked the fifth month of the selloff. There’s no end in sight. Even a tactical rally now seems like a dubious proposition to some observers. “It no longer makes sense to own equities,” one strategist sighed, while abandoning a call for a tradable bounce.

The figure (below) illustrates Chadha’s point. The current selloff is 34 sessions longer than the median non-recession correction.

Chadha and Thatte walked through a hodgepodge of figures and statistics which together suggest the market sees “an imminent recession.” Stocks are pricing an ISM of 40, for example, and a ~20% decline in earnings.

The data tells a different story. Payrolls may be a lagging indicator, but the US labor market is still strong, notwithstanding the uptick in jobless claims and this week’s cringeworthy regional Fed surveys. Chadha said there are “no signs” of big capex cuts just yet and leading indicators don’t signal a downturn tomorrow.

That said, Deutsche Bank cautioned we’re late cycle, and noted that even with this year’s de-rating, multiples are far from low. At ~16.5, the S&P’s forward P/E is merely back in the range seen from 2015 to 2019.

The valuation point is important because, as Chadha emphasized, selloffs are “well explained by initial valuations and earnings declines.” If there’s a recession, one pretty much has to assume a drop in earnings commensurate with historical downturns, but considering the extremely elevated starting point for multiples, the accompanying equity drawdown could be deeper than the historical median (24%).

“In the event we slide into a recession imminently, we see the market selloff going well beyond average,” Chadha wrote, suggesting the S&P could fall between 35% and 40% to around 3,000. The scatterplot (above) illustrates the point.

But it’s not just a valuation and earnings story. Generally speaking, stocks bottom in the middle of recessions. The recession hasn’t even started yet, or at least not that we know of. Assuming we’re in a recession now, stocks would bottom sometime in November which, I’d note, would be extraordinarily inconvenient for Democrats and the White House, albeit totally consistent with the Biden administration’s unfathomably bad luck.

Additionally, Chadha noted that although equity outflows have picked up, we’re nowhere near any kind of wholesale exodus. Remember: 2021 was a bonanza for inflows to global equity funds. We’re just starting to see that reverse (figure below).

The implication: There’s a long way to go in any kind of recessionary scenario.

As for buybacks, Chadha wrote that although the corporate bid is still supportive for stocks, it’s obviously tied to earnings. “In a recession, an earnings decline would also mean lower buybacks as they tend to be highly cyclical,” he said.

For discretionary investors to get more bullish, the growth scare needs to abate. For systematic cohorts to re-leverage, vol needs to recede. Neither of those two conditions are met right now. Between that, the late cycle dynamic, still elevated multiples and the “sticky inflation” that’s keeping the Fed in full-hawk mode, Deutsche Bank expects the S&P “to at least price in a full recession decline of -24%.”

From there, Chadha said, “the outlook looks relatively binary.” Either the US falls into recession or it doesn’t. If it does, the S&P could drop to 3,000, as noted above.

One shudders to think where the index might end up in some manner of worst case scenario that finds the world’s largest economy succumbing to a “major recession.” Fortunately, almost no bank is predicting such a thing.