‘Capitulation Events’ And ‘Nightmare Scenarios’

The rates-driven, valuation compression stage of the bear market may be mostly behind us assuming inflation moderates going forward, but “it could be a case of out of the frying pan, into the fire.”

That’s according to BNP’s Greg Boutle and Maxwell Grinacoff, who see “a capitulation event in equities next year,” when the US is likely to fall into recession thanks in no small part to the lagged impact of the most aggressive Fed tightening campaign since Paul Volcker.

Higher rates in 2022 led to a dramatic de-rating across richly-valued growth shares and torpedoed the housing market, but the broader economy hasn’t yet succumbed. Most macro strategists (not to mention big bank CEOs and the yield curve) see elevated odds of a downturn in 2023, and that could usher in the next (and, one hopes, final) phase of the bear market.

“Recessionary bear markets historically have often ended with a capitulation,” Boutle and Grinacoff wrote, suggesting that 2002 is perhaps the best analog for the current equity regime. “The bull market that ended last year had notable similarities to the late 1990s,” they said, flagging retail investor participation, “massive P/E multiple expansion” (particularly in growth shares and tech) and outperformance from unprofitable enterprises with “speculative ambitions.”

The figures (below) are useful for context.

This year’s five-point de-rating “is the largest valuation contraction since 2002,” BNP remarked, adding that back then, the S&P troughed with a P/E of ~14x. If you apply that to the bank’s forecast for index-level 2024 EPS ($231) you get ~3,250. I’d note that 3,000 to 3,250 is a popular range when it comes to bear cases from top-down sell-side strategists.

Boutle and Grinacoff also pointed out that although the valuation premium for growth shares versus their value counterparts has compressed quite a lot, it’s still more than five points above the 2003 trough.

The bottom line from BNP (and I realize we’re not exactly breaking any new ground here, but on some days, there’s just not much new ground to break) is that 2002 was “quite representative” of recessionary crashes looking back 100 years, so if the current bear market is destined to be remembered as a recessionary crash, and 2002 is the best analog, then US equities could trough in the middle of next year, with the S&P bottoming “close to 3,000, and with the VIX in the low 40s.”

Meanwhile, SocGen’s outlook for US equities in 2023 includes a base case of no earnings growth, but in a “smooth soft landing” (defined by “no employment shock” and moderating inflation) earnings could grow 10%, and the S&P could see 4,200 by year-end. Anything higher than that would need sub-2% core inflation, an ostensibly far-fetched outcome.

As for SocGen’s worst-case scenario, the bank actually offered two downside cases, one they called “realistic” and the other a “nightmare” (table on the right, below).

The “realistic” downside scenario entails a 10% decline in earnings, a front-loaded recession through 2023 and a Fed that “reverses earlier than we currently expect” ahead of stronger growth in 2024.

SocGen defined the “nightmare scenario” as a “1970s-type” situation, where a more aggressive Fed drives equity multiples down to just 12x, chasing the S&P to 2,500 in the process.

Mercifully, the language employed by the bank’s analysts didn’t suggest they see the latter scenario as especially likely. “We expect the index to trade in a wide range as we see negative profit growth in 1H23, a Fed pivot in June 2023 and a US recession in 1Q24,” the bank said, suggesting the index will swing between 3,500 and 4,200 before settling around 3,800 this time next year.