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Valuation Math Suggests Difficult Markets in 2023

Published 12/16/2022, 01:15 PM
Updated 02/15/2024, 03:10 AM

In 2023, the math of valuations suggests returns will likely be challenging as markets remain difficult to navigate.

Estimating price targets for the next full trading year is an exercise in futility. Too many variables, from politics to economics to monetary and fiscal policies, can impact market outcomes. However, we can build some ranges based on current valuations when estimating possible and probable returns for the following year.

As discussed previously, using forward operating earnings for any analysis is flawed. The reason is that forward operating earnings today will not be at the same level in the future. Since May 2022, forward earnings estimates have declined by 15%. We suspect estimates will fall further, making forward valuation assumptions unreliable.S&P 500 Forward EPS Estimates

When analyzing historical valuations, a shift higher occurred as the Federal Reserve became active in monetary policy. The long-term historical median valuation from 1871 to 1980 is 15.04x earnings. When including 1980 to the present, that long-term media rose to 16.44x earnings. However, as the monetary and fiscal policies employed kept “mean-reverting” events from happening, valuations jumped to 23.38x earnings since 1980.

S&P 500, CAPE, Real GDP, Cyclically Adjusted P/E

This analysis gives us three baselines for estimating next year’s potential return ranges. We will have to make several assumptions:

  1. We will use Wall Street’s current earnings estimates for a “Soft-Landing Recession” and “No Recession” scenario of $205/share, assuming only valuation adjustment.
  2. We will use Wall Street’s estimates for fair value at 17x earnings for a “No Recession” scenario and 15x for a “Mild Recession” outcome.
  3. In a “Recession” scenario, we would expect $160/share earnings, equating to a reversion to the growth trend. (Shown below). We will use a valuation adjustment or 15x and earnings reversion to account for a “deep recessionscenario.

As noted, the current earnings estimates for 2023 remain well above the long-term historical 6% peak-to-peak earnings trend throughout history. We will use the recent 15% decline in earnings estimates for the “soft landing” scenario, but history suggests sustaining earnings at these levels will likely prove problematic.S&P 500 Earnings Estimates

Estimating the Outcomes

The problem with current forward estimates is that several factors must exist to sustain historically high earnings growth.

  1. Economic growth must remain stronger than the average 20-year growth rate.
  2. Wage and labor growth must reverse to sustain historically elevated profit margins, and,
  3. Both interest rates and inflation must reverse to very low levels.

While such is possible, the probabilities are low, as strong economic growth can not exist in a low inflation and interest-rate environment.

However, with that said, we can use the current forward estimates, as shown above, to estimate both a recession and non-recession price target for the S&P 500 as we head into 2023.

In the NO-recession scenario, the assumption is that valuations will fall to 17x earnings over the next year. If such is the case, based on current estimates, then the S&P 500 should theoretically trade at roughly 3500. Given the market is trading at approximately 4000 (time of this writing), such would imply a 12.5% decline from current levels.

S&P 500 Price Estimate with No Recession

However, should the economy slip into a “soft landing” or mild recession and valuations revert to the longer-term median of 15x earnings, such would imply a level of 3100.

S&P 500 Estimate With Soft Landing Recession

While an additional 22.5% decline from current levels seems hostile, such would align with typical recessionary bear markets throughout history.Recession Table

However, in a “deep recession” scenario, we expect a valuation and an earnings reversion (15x valuations on earnings of $160/share). Such would imply a price target of 2400 or a decline of roughly another 40% from current levels.

S&P 500 Estimate With Deep Recession

While such seems like an unduly large correction from current levels, there are previous precedents in history to suggest the possibility. Such would also align with the Federal Reserve “breaking something” in the credit markets, which impairs market functioning.

The chart below plots both paths for the S&P 500 for a better visual.

S&P 500 Recession Deep Recession Price Forecast

Optimistically, we saw the market’s lows in September, and a retest next year will bring valuations down to 17x earnings. Pessimistically, a recession will pull the market below the 2019 peak and revert valuations to 15x earnings, with earnings reverting towards historical growth trends.

Could There Be a Bullish Scenario?

We would be remiss in not giving some assessment for a bullish outcome in 2023. However, for that bullish outcome to take shape, we must consider several factors.

  1. We assume the $205/share in year-end estimates remains valid.
  2. That the economy avoids a recession even as inflation falls
  3. The Federal Reserve pivots to a lower interest rate campaign.
  4. Current valuations remain static at 22x earnings.

In this scenario, the S&P 500 should rise from roughly 4000 to 4500 by the end of 2023. Such would imply a 12.5% gain for the year. However, such would not recoup the losses from the market’s peak in 2022.

S&P 500 Price Target With Multiple Expansion

Adding the bullish scenario to our projection chart gives us a full range of options for 2023, which run the gamut from 4500 to 2400, depending on the various outcomes.

S&P 500 Estimates For Recession and Non-Recession Scenarios

Here is our concern with the bullish scenario. It entirely depends on a “no recession” outcome, and the Fed must reverse its monetary tightening. The issue with that view is that IF the economy does indeed have a soft landing, there is no reason for the Federal Reserve to reverse reducing its balance sheet or lower interest rates.

More importantly, the rise in asset prices eases financial conditions, which reduces the Fed’s ability to bring down inflation. Such would also presumably mean employment remains strong along with wage growth, elevating inflationary pressures.

While the bullish scenario is possible, that outcome faces many challenges in 2023, given the market already trades at fairly lofty valuations. Even in a “soft landing” environment, earnings should weaken, which makes current valuations at 22x earnings more challenging to sustain.

Is a Recession Inevitable?

While the “no recession” case is possible, we struggle with that view.

With the Federal Reserve committed to continued rate hikes in 2023, reducing market liquidity through Quantitative Tightening, and the consumer struggling to make ends meet, the risk of a recession seems quite elevated.

However, if employment remains strong, unemployment doesn’t rise, and wages continue to rise to offset inflation pressures, then it is possible to avoid a recession. The problem is that strong employment and wage growth will add to inflationary pressures. Of course, that is what the Federal Reserve is actively trying to resolve.

A recession seems highly probable if the Fed’s end game is higher unemployment and lower inflation through higher interest rates, which will ultimately slow wage growth. The economic data already seems well tilted into a recessionary trend. However, the composite economic index declines further during a recession, suggesting a deeper reversion in the stock market.

Economic Composite Indicator vs. S&P 500 YoY ROC

Given the Fed’s ongoing monetary tightening, the risks seem tilted toward weaker economic outcomes. However, as stated previously, the Fed will reverse course when something eventually breaks.

The bullish expectation is that when the Fed finally makes a “policy pivot,” such will end the bear market. While that expectation is not wrong, it may not occur as quickly as the bulls expect. Historically, when the Fed cuts interest rates, such is not the end of equity “bear markets,” but rather the beginning. Such is shown in the chart below of previous “Fed pivots.”

Fed Funds and Bear Markets

Our best guess is that reality lies somewhere in the middle. Yes, there is a bullish scenario where earnings decline, and a monetary policy reversal leads investors to pay more for lower earnings. But that outcome has a limited lifespan as valuations matter to long-term returns.

As investors, we should hope for lower valuations and prices, which gives us the best potential for long-term returns. Unfortunately, we don’t want the pain of getting there.

Regardless of which scenario plays out in real-time, there is a substantial risk of poor returns over the next 12 months.

That is just the math.

Latest comments

CAPE/PE10 is 27.42( Shiller fan ) which would lead me to believe in your lower end target.
One of the best forward projecting analyses I've read. Thank you very much for the insights gained from this.
sir how are you tomorrow analysis of Gold
between 1980 and 2000 markets went up 15x between 2000 and 2020 markets only went up 1.5 x so markets haven't done much in the past 20 years.
in 1988 interest rate were going down and the market up, in 2000 markets were going down so fed lowered interest rates to help markets, the same in 2008 there was a crash interest rate when down to help markets. now markets are up so interest rate also going up to catch up with record markets. if there is a crash then story will repeat lowering rates to help markets. so it has nothing to do with when fed lowers rates markets go down, rates go down to help crashing markets. No need to lower rates if markets and economy is doing well. live with higher rates they are very low anyway.
No matter what numbers show, the only thing that matters is FED behaviour. There is no point now to invest in stock market when you can buy 10 years bonds at more than 6% interest. There is no point in trying to make business when you can just simply get a 6% yearly gain by doing basically nothing. So economy slowdown is a certain thing.
Hedge Fund manager Bill Harnish (+29% in 2022) sees the SPX/SPY in a trading rsnge of 3500-4500 over the next 18-36 months (Bloomberg).
Very informative article. It details all scenarios. Thanks Lance Roberts!!
Excellent article and research for any serious investor or trader. Thanks for posting and graphing. With so manyconflicting macroeconomic trends it is hard to predict 2023. However, this is not gonna be like 2008. So no worst case. But even a soft landing no recession will not be best case either. S&P 3500-3900 is my best guess. Other things being equal, of course.
One of the best articles I've ever read on this site. Thanks
thank you for sharing all the technical charts. unfortunately looking forward and thinking we can estimate valuations is a fools errand.
This guy gets it. I think it was Goldman Sachs analysts that predicted in the summer oil would hit $200 in December. Just think, people actually invest based on predictions of "experts". Sad. Let me help. I don't care if you have a PhD and are a technical analyst. No one, ahem, No One knows what the market or economy will do next week, never mind next year.
sigh... higher interest rates doesn't stop inflation, it merely kills demand, it is not the same thing
dropping demand lowers prices, which will reduce inflation.
Md razu ahamed
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