A ‘Challenging’ Path Forward

You wouldn’t know it to look at the outsized gains across benchmarks in 2023, but equities face “a challenging distribution of outcomes,” as Goldman’s David Kostin euphemistically put it.

Ironically, the fact that stocks ran so far, so fast during the first several weeks of the new year is part and parcel of why that distribution is so challenging. If there was a case to be made for stocks coming out of the worst year since the financial crisis, surely the gains already notched have weakened that case.

As discussed here, multiples have expanded well beyond what could plausibly be justified by the (admittedly sizable) drop in real yields in January. US equities are now trading at 18 times forward earnings, and if you think earnings are likely to disappoint, stocks are effectively trading even richer than that.

I doubt anyone needs to have the risks enumerated, but just in case, Goldman walked through them in a note published following another week of gains for big-cap US tech.

“A soft landing is already priced in the US equity market,” Kostin wrote, citing enormous outperformance from cyclicals, which maps to 2% real GDP growth and an ISM of 55, neither of which are consistent with what’s likely to unfold going forward. If you suspect, as Kostin does, that a benign macro outcome is already in the price, then even if the Fed lands the plane safely, there’s not much fundamental upside for stocks — or at least not from current levels.

Further, if the economy does outperform expectations, then the probability of Fed easing will decline commensurately, and yields might rise. Given the re-rating from cycle lows in multiples, Goldman thinks “substantial further valuation expansion will be unlikely” in the event Treasury yields move higher again.

Finally, earnings growth will probably be anemic for quite a while, regardless of whether the world’s largest economy skirts a recession. Consensus expects aggregate profit growth for corporate America to be essentially flat this year, but expects a sharp rebound to 12% EPS growth in 2024. Goldman isn’t so sure.

“Since the end of June 2022, 2023 EPS estimates have been cut by 10%, double the historical pace of negative revisions [and] measures of revision breadth recently had been as negative as in 2008 and 2020,” Kostin went on.

Morgan Stanley’s Mike Wilson is, of course, overtly bearish on corporate profit growth, and his dire prognostications about the drag from negative operating leverage are now becoming consensus.

As the figure above from Goldman reiterates, there’s obviously substantial downside for earnings in an outright US recession. The fact that multiples have re-rated is problematic in that context. Although it’s probably a safe bet to assume the market won’t assign a trough multiple to trough earnings, the recent P/E expansion self-evidently raises the odds of another round of de-rating, which could pretty easily coincide with weaker earnings as the economy grapples with the drag from 450bps of already-delivered Fed tightening.

“We estimate the S&P 500 would fall to 3,150 in a recession scenario, driven by a combination of falling earnings estimates and a much lower P/E multiple (14x vs. 18x today),” Kostin said.

And all of that’s to say nothing of the tail risk associated with inflation that refuses to recede to target, exhibits unwelcome volatility (given geopolitical and macro uncertainty) or, just as likely, a combination of both.