S&P500 has 15% Downside

What is the downside risk? On Fed Funds rate headed to 4% the SP500 could have a further 15% decline.

Given that inflation is not moderating and becoming anchored, entrenched or part of the business and consumer psyche, the Fed, ECB and many central banks have and are raising rates to quell demand, to force a slowdown. However, this soft landing rarely occurs, and GDP swings lower, into recession or negative territory for half a year or more. How bad is the GDP decline depends on many factors and impacts each sector, each company differently.

Under three different GDP/EPS scenarios (See chart 1), plus multiple compression, the SP500 could have a further 15% decline. The Consumer Discretionary, Industrial, Tech and Utilities look to have more downside. Energy (oil), Financials, Materials and Real Estate the best situated.

Two Forces

1-Rate hikes are used to cut demand and that impacts GDP growth and Earnings growth and that hurts share prices. 

YE23 earnings growth forecast is 9%, under a soft, mild, or hard landing scenario, earnings will decline.

Under three lower GDP/EPS growth scenarios (See chart 2) I assume a 3%, -5% and -10% impact vs consensus YE23 EPS growth of 9%. I further break this down per sector in the SP500. As can be expected, Consumer Discretionary, Industrial, Materials and Energy are the most impacted.

2-At the same time valuation multiples compress on higher rates, the time value of future earnings falls. While less risky investment alternatives have higher appeal, money flows. (See chart 3)

This means the PE ratios (or other valuation measures) fall. Instead of pricing stocks at 20x PE the market drops this to 16x for example.

As can be seen in the chart below, PE multiples for the SP500 are about 10% above long-term trends and under a 4% Fed Funds. However, certain sectors are more expensive and could suffer higher multiple compression. The value of a company’s earnings falls.  Some sectors, Energy (oil) and Materials are at a discount due to “over earnings” on the spike in commodity prices. Financials, Real Estate and Health Care seem fairly priced. Utilities, Information Technology and Consumer discretionary far above.

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