By David Rosenberg and Brendan Livingstone

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David Rosenberg: S&P 500 could drop as low as 2,500 before this bear market is finished Back to video

One of our key themes this year has been that earnings estimates were wildly optimistic. Analysts are now beginning to come around to this view, with 2023 S&P 500 earnings per share (EPS) being trimmed to US$237 from a peak of US$249. However, if a recession hits next year — our base case — there is still a lot further to go in terms of the stock market discounting a realistic earnings profile.

Indeed, based on the historical path of revisions in recession years, we may ultimately see 2023 earnings wind up at US$177 per share (25 per cent below current expectations). If we assume an unchanged price-to-earnings multiple, this points to the S&P 500 falling to 3,000 before the bear market is complete. But there is the potential for additional downside from this level. A “normal” recessionary trough multiple is about 14x, which would put the S&P 500 at 2,500.

Around recessions, analysts are very slow to adjust their earnings estimates. This not only leads to a false sense of security — on the belief that the earnings hit will not be that severe — but it also makes valuations appear more attractive than is actually the case.

For example, the S&P 500 is currently trading at 16.8x next year’s earnings, but what if this estimate is 10 or 20 per cent too high? Well, then we are talking about a “true” multiple of 18.7x and 21x, respectively. No one would be talking about the market being fairly valued at these P/E ratios, especially given where interest rates are currently.

We examined the evolution of earnings revisions during past recessionary periods

With that in mind, we examined the evolution of earnings revisions during past recessionary periods. Our dataset begins in 1990, which gives us four recessions to work with: 1990-1991, 2001, 2007-2009 and 2020. Each year of estimates has 24 months of revision data, from January of the year prior to December of the year in question. We then plotted the evolution of the 2023 estimate versus the average trajectory during recessions and found it is very closely tracking the average revision during recessionary periods.

From our standpoint, there are a couple of key takeaways from this similarity. First, although the trend has flipped negative, the pace of downgrades really begins to accelerate over the next six to 12 months. Put differently, investors should be braced for EPS cuts to pick up steam in the coming quarters.

Second, if the evolution of the 2023 earnings estimate continues to track the average trajectory during recessions, this implies an EPS level of US$177 per share by December of next year. For context, this is 25 per cent below what is priced in at the current time, representing meaningful downside risk to embedded estimates.

Should this ultimately unfold, we have little doubt that the stock market would succumb to lower lows. After all, even under the (optimistic) assumption of an unchanged P/E ratio, a 25-per-cent hit to earnings would imply an S&P 500 level of roughly 3,000. If, instead, we use the 14x trailing P/E multiple that typically marks bear market lows, we could ultimately be talking about the S&P 500 reaching 2,500 when all is said and done.

Bottom line: the historical record during recessions shows we could be in the very early stages of a period of negative revisions for earnings — in baseball parlance, we are talking about the third inning. As a result, we believe the bear market has further to go — both in terms of duration and magnitude — with an ultimate low for the S&P 500 somewhere between 2,500 and 3,000.

Although the stock market will bottom before the trough in earnings (based on what has consistently happened historically), a more realistic path for earnings will still need to be discounted before the bear market reaches a conclusion.

With this in mind, we would use the recent period of strength in the equity market to take profits and raise cash. We fully expect better buying opportunities to arise down the road when a recession is fully “in the price.”

David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. Brendan Livingstone is a senior markets strategist there. You can sign up for a free, one-month trial on Rosenberg’s website.

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