The stock market has been in selloff mode ever since October, and things aren’t getting any prettier as we head into the end of the year. At current levels, the S&P 500, Dow Jones\ and Nasdaq are all in correction territory. All three are also negative for the year. And, the consensus investor sentiment out there is that the stock market will remain weaker for longer.
But that’s all qualitative talk. What do the numbers say?
Are we heading into a recession? If so, how long will it last? How far will the stock market fall? What if we don’t head into a recession? How much can the stock market rise?
All those questions require a look into corporate earnings. In the big picture, corporate earnings are really all that matters for the market. Just look at a chart of the S&P 500 index next to S&P 500 earnings. As go earnings, so goes the stock market.
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Thus, if you want answers as to where the stock market will go next, look at the earnings picture. Specifically, look at the historical earnings picture. Analyze prior recessions and corrections. See how much sales fell, how far margins dropped, and where earnings bottomed. Note where valuations settled. And, put all that in context with what’s going on today.
What will find you find? The stock market isn’t priced for a huge recession. But, it is appropriately priced for slowing growth. Thus, unless we are heading into a recession as bad as the ones that hit in 1929 or 2008, the stock market should march higher in 2019.
Here’s What History Says
Using data available from S&P Global, I’ve looked at three key S&P 500 metrics over the past twenty years:
- Sales per share
- Corporate profit margins
- P/E multiple
Click to EnlargeOn the sales per share front, we see that S&P 500 revenues normally track higher so long as the economy is healthy. Once the economy falters, however, revenues drop. The size of that drop depends of the magnitude of the correction and/or recession. During the dot-com crash, S&P 500 sales dropped 10% peak-to-trough over the course of seven quarters. Meanwhile, during 2008-09, sales dropped a whopping 16% in just four quarters. From 2015-16, sales simply fell 3% over four quarters.
Thus, over the past twenty years, there have been three sales downdrafts for the market. They’ve knocked anywhere from 3% to 16% off sales, and have lasted usually one to two years.
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On the corporate profit margin front, much like sales, S&P 500 profit margins tend to track higher in a healthy economy. That isn’t the case during economic downturns. In 2008-09, profit margins for the S&P 500 were cut in half and dropped all the way 4%. Meanwhile, in 2015-16, profit margins fell roughly 100 basis points and bottomed around 8.5%. Following the dot-com crash (not pictured, but can be seen here), profit margins fell roughly 200 basis points and bottomed around 6%.
Thus, over the past twenty years, there have been three margin downdrafts for the market. They’ve chopped profit margins by 100 to 500 basis points, and usually bottom in the mid- to high-single-digit range.
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Interestingly enough, the market tends to compensate somewhat for depressed recession and correction earnings through multiple expansion. Over the past twenty years, during each earnings downdraft, the market’s trailing P/E multiple has moved to above 20 (versus an average of 18). Moreover, during more serious earnings routs like in the early 2000s and 2008-09, the P/E multiple goes above 25, and usually touches north of 27.
Where the Stock Might Go in 2019
Broadly speaking, we have four different scenarios for the stock market next year. They are as follows:
- Growth is normal, and earnings are fine.
- Earnings have a minor slowdown like in 2015-16.
- We have a normal recession like in the early 2000s.
- We have a bad recession like in 2008-09.
According to my numbers, the stock market will rally in scenarios one and two, trade sideways in scenario three, and drop further only in scenario four.
Let’s take scenario No. 1. Consensus earnings for next year sit north of $175 per share. A historically average 18 trailing multiple on that implies a 2019 end price target for the S&P 500 of 3,150. That represents 20%-plus upside from here.
In scenario No. 2, you will see sales drop roughly 3%, profit margins compress about 100 basis points to 11%, and the P/E multiple rise to about 20 like it did in 2015-16. In that scenario, market EPS will likely settle around $140. A 20 multiple on that implies a 2019 price target of 2,800, roughly 10% upside form here.
In scenario No. 3, sales will drop roughly 10%, profit margins will compress more than 200 basis points to around 8.5%, and the P/E multiple will rise to about 25 like it did in 2008-09 and the early 2000s. In that scenario, market EPS will likely settle around $100. A 25 multiple on that implies a 2019 price target of 2,500, roughly in-line with where the market trades today.
Scenario No. 4 is the doomsday scenario. Everything blows up. Sales drop more than 15% like in 2008-09. Profit margins get cut in half. The P/E multiple rises to 27 to compensate for super depressed earnings. In that scenario, market EPS will likely settle around $70. A 27 multiple on that implies a 2019 price target below 1,900, or about 25% more downside.
Bottom Line on the Stock Market
Realistically speaking, there are four scenarios for the stock market next year. We either get growth as normal, a slight hiccup like in 2015-16, a minor slowdown like in the early 2000s, or a big recession like in 2008-09. Growth as normal implies 20%-plus upside in 2019. A slight hiccup implies 10% upside. A minor slowdown implies sideways trading. And a big recession could result in a 25% wipe-out.
At this point in time, a big recession looks unlikely. It is far more likely 2019 plays out like one of the three other scenarios. As such, the stock market should end 2019 somewhere between 2,500 and over 3,000, meaning that we may indeed be near a stock market bottom.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.