Another Monday, another week that’s likely to be spent listening to all the scariest stories Wall Street can tell about bear markets, recessions and the end of life as we know it. This time, it’s mighty Goldman Sachs, which started beating the bear drum a few months ago on the yield curve being a sign of the apocalypse.
The yield curve recovered. And even now, Goldman concedes that there’s at worst a 1 in 3 chance of an active recession in the next 18 months. Guess what? Recessions statistically happen every 38 months or so, and because the post-COVID expansion started 21 months ago, those odds are actually on the low side.
Just do the math. If this cycle is weaker than “average,” we’d expect the expansion phase to be weaker as well . . . and probably shorter. We’d expect that secondary recession faster than normal. The boom would be pretty unlikely to last a full 38 months.
And yet Goldman’s bears are saying the odds of that happening are worse than a coin flip. Far from a sure thing. In theory, there’s a 65% chance of the economy powering on beyond 2023 before hitting any walls. That’s a longer expansion than statistics would suggest on their own.
How is that possible? Part of the answer is that Goldman’s gurus know the most fundamental rule of modern Wall Street. They helped write it. You don’t fight the Fed . . . and the Fed does not want a recession before the economy is strong enough to tolerate normal interest rates.
Powell and friends want a cooler job market. But if it gets so cold out there that millions of people start getting laid off, interest rates go back to zero mighty fast. We’ve seen that story play out a few times now over the past decade. It’s the new normal.
But the other part of the answer is that Goldman’s gurus know modern Wall Street runs on drama. Extreme scenarios capture the imagination and the emotions as well. When greed doesn’t sell, there’s always fear.
They want a little more fear out there to force the market to capitulate. Then, maybe, serious investors can get back to work and stocks can rebuild.
In the meantime, good news is actually out there. You just have to cut through the noise to find it. That yield curve that Goldman was so concerned about six weeks ago has almost completely healed. Look at it today and it’s not pointing at a recession at all.
And while stocks got inflated in the free-money era, they’ve come down almost far enough to qualify the current market mood as “normal.” Not cheap, but not exuberant either.
The multiple on the S&P 500 is now below the 5-year average. Granted, the last five years have contained their share of excesses and crises, but on the whole the period only pushed our sense of “normal” to about 18.6X future earnings.
That’s pretty high. But it’s far from extreme, and in most of those years the really extreme factor was near-zero interest rates. (A once-a-century pandemic only got the Fed moving.)
And talking about statistics, because valuations were high in the past five years, we’d expect them to come down a bit in the next five years. The long-term math needs to balance out.
In that scenario, maybe the S&P 500 spends a little time trading at 13-14X earnings. That’s roughly where multiples were in 2007-12, when the world was going into the 2008 crash and then coming out the other side.
To get there in the next year, that means the market needs to drop another 10% and stay there while earnings keep building up behind it. That’s a worst-case scenario.
Goldman says it’s more likely that the market will climb another 10% from this level by the end of the year. In a recession case, we might see massive selling . . . but in a year or two, the wounds will heal.
This isn’t hype or horror. It’s just statistics. But it’s how long-time market participants grow what they have over time.