- Stocks have enjoyed an 8% rally since the start of 2023.
- But that’s due to turn around in the second half of the year, says John Lynch.
- Lynch warns the S&P 500 will retest October lows of 3,491.
Comerica Wealth Management’s Chief Investment Officer John Lynch says the relief that stock-market investors have seen so far this year is about to end.
Year-to-date, the S&P 500 is up 8%. But in a note to clients on Friday, Lynch warned that the index is due to weaken in the near future with a recession on the horizon. He said it would return to levels near October 2022 lows of 3,491, which would represent 15% downside from current levels around 4,130.
“After a solid run, the S&P 500 Index finds itself at the top end of the trading range following its emergence from the October low,” Lynch said. “We believe the combination of declining earnings, weakening economic growth, a steadfast Federal Reserve, and a lack of broad participation suggests the equity market is poised to struggle in the weeks and months ahead.”
Lynch sees several factors lining up to work against stocks. At the top of his list is the pullback in earnings he expects.
Analysts expect the S&P 500’s first-quarter earnings to be negative for the second straight period, according to FactSet data cited by Lynch. He believes rising wage costs and falling consumer demand — which will continue to get hit by a hawkish Fed — support this thesis.
Then there’s valuation. The S&P 500’s forward price-to-earnings ratio is 19, above the average over the last 20 years. Plus, when the Consumer Price Index is between 4-6% like it is now, it usually dictates that the S&P 500 trades at a lower multiple than it is.
“To be sure, inflation has come down from its 9.0% YOY peak last year, and the recent March CPI report showed a 5.0% YOY gain. Data since 1970 shows that in previous periods when inflation hovered at these levels, the S&P 500’s P/E was just 15.5 times earnings, suggesting current equity prices may run into resistance until either earnings climb or stocks drop,” Lynch said.
When looking at stock valuations relative to bond yields, they also remain at historically high levels. This is known as the equity risk premium.
Stock investors typically seek to get compensated with higher returns than one would receive investing in risk-free Treasury bonds. With bond yields high right now, the equity risk premium is at its lowest levels since around 2007, meaning stocks look the most unattractive relative to bonds since then.
“The ERP is calculated by taking the earnings yield, which represents the inverse of the S&P 500’s P/E ratio and subtracting the yield on the benchmark 10-year U.S. Treasury note,” Lynch said. “For example, at the current S&P 500 P/E of 19, the earnings yield for stocks is 1 divided by 19, or ~5.2%. Subtracting the yield on the 10-year Treasury note (~3.50%) results in an equity risk premium of approximately 170 basis points, which is below the 20-year average of almost 320 basis points.”
Lynch said he believes investors will start pricing in a recession in the second half of this year, which begins in July. While he sees 15% downside in the months ahead, he also believes the S&P 500 will return to current levels by the end of 2023.
What others are saying
Lynch’s argument around valuations has many proponents on Wall Street.
Morgan Stanley’s Mike Wilson and Societe Generale’s Albert Edwards both warned earlier this year that the equity risk premium was in the “death zone” for stocks.
Wilson has also repeatedly warned of an earnings recession ahead, and recently said that the pullback in lending from banks strengthens his case.
“The earnings situation is way worse than what the consensus thinks,” he told Bloomberg earlier this month. “The banking stress only makes us even more confident of that.”
He added in a note this week: “The data suggest a credit crunch has started.”
Like Wilson said, tighter lending standards leading to this decline in credit availability boost the chances that a recession will occur. Bank of America warned last week that companies would soften their outlook as a result of the so-called credit crunch.
“We forecast an in-line quarter, but the focus will be on guidance and tighter credit conditions impacting capex/buybacks,” the bank said in a note.
Heavy hitters in the financial world have chimed in recently warning of heightened recession risks — including Mohamed El-Erian, Jeremy Siegel, and Jeffrey Gundlach.
However, some think a soft-landing scenario, where the Fed succeeds in bringing down inflation and keeps the economy from entering a recession, is still possible. Morgan Stanley’s Chief US Economist Ellen Zentner said in a note on Friday that a bottoming in housing activity would help save the US economy from recession.
“As other parts of the economy are slowing, a cycle bottom in housing provides an important cushion in our soft landing thesis.”
Still, many recession signals, like the inverted Treasury yield curve and The Conference Board’s Leading Economic Index, show a downturn is ahead. If a recession does come to fruition and earnings take a hit as a result, it’s likely that a 15%-plus downside scenario — a view shared by Lynch, Wilson, Bank of America’s Savita Subramanian, Crossmark Global Investment’s Bob Doll, GMO’s Jeremy Grantham, and more — plays out.
Read the full article here
