[Editor’s note: “Muscle Through a Recession With Growth Stocks” was previously published in September 2022. It has since been updated to include the most relevant information available.]
The stock market has been getting crushed this year. It’s clear that we’re in the middle of a bear market. And it seems likely that the U.S. will see a recession within the next 12 months. That’s if it’s not there already.
That may sound scary. But it shouldn’t be.
Recessionary periods and bear markets create once-in-a-decade buying opportunities in the stock market.
In other words, recession risks are rising, and the broader markets are highly volatile. But we’re growing very bullish on a particular group of stocks right now.
Historically, crises have created opportunities. This time is no different. And the opportunities we’re anticipating are potentially life-changing.
So, don’t freak out.
The best thing to do during a bear market or recession is to hunker down in stocks that will soar once the downturn passes.
The Hawkish Fed
The Fed will keep hiking rates. It’s made that abundantly clear. But the economy is slowing. So, we have a stubborn Fed dead-set on hiking interest rates into a rapidly slowing economy. That’s a situation very likely to result in a recession. And depending on the Fed’s policy path, it could even lead to a deep recession.
A mild-to-moderate recession is priced into U.S. stocks. A deep one is not — though the chances for a severe recession are still very low. And even though a downturn sounds scary, it doesn’t have to be the end of the world. That’s especially true if you’re invested in the right stocks.
Indeed, the biggest stock market returns of this century happened in the 12 months after bear-market bottoms. And to understand why, we need to zoom in on what really drives stocks.
How Recessions Impact Earnings
At the end of the day, only two things matter for stocks: Earnings and the multiple that investors are willing to pay for these earnings. Mathematically speaking, earnings (x) P/E Multiple (=) Stock Price.
Therefore, to understand how a recession might impact stock prices, we need to understand how a recession will impact earnings and multiples.
Let’s tackle earnings first.
Recessions always negatively impact earnings. But the magnitude of the impact varies widely. Our historical analysis indicates there are three types of earnings recessions:
- Shallow: EPS tends to drop about 10%.
- Moderate: EPS tends to drop about 20%.
- Severe: EPS tends to drop over 40%.
Our understanding of the current macroeconomic fundamentals, as well as the drivers of a potential recession in 2023, strongly suggest that a shallow recession is most likely. A moderate recession is somewhat likely, and a severe recession is very unlikely.
The S&P 500’s EPS is set to finish this year at $225. Therefore, a shallow recession would bring 2023 EPS to about $200, while a moderate one would push 2023 EPS down to $180.
That means that the market is already priced for both scenarios.
The Impact on Multiples
Believe it or not, recessions tend to positively impact equity multiples.
That’s because a recession marks a period of prolonged economic contraction. In times like that, the Fed tends to cut interest rates. And investors usually flock into risk-free investments like the U.S. Treasury. As a result, Treasury yields fall during recessions. Equity multiples are inversely correlated to Treasury yields. So, as yields fall, equity multiples tend to rise.
Specifically, every time the S&P 500’s EPS drops during a recession, the S&P 500’s P/E multiple tends to pop into the 23X to 30X range. This happened in the late 1980s, early 1990s, early 2000s, 2008/09, and 2020.
We don’t see any reason this time would prove different.
On the conservative side, then, the S&P 500’s P/E multiple should rise to 23X in 2023 in the event a recession hits and earnings drop. In a shallow recession, a 23X multiple on $200 in EPS implies an S&P 500 price target of 4,600 – up about 25% from current levels. In a moderate recession, a 23X multiple on $180 in EPS implies an S&P 500 price target of 4,140 – up about 10% from current levels.
We conclude, then, that the stock market is fully priced for a shallow or a moderate recession. If either strike in 2023, stocks should still rally big next year.
The only risk here is if the 2023 recession is a deep one. In that scenario, stocks would fall further. But given the strength of the consumer, labor market, and enterprise balance sheets, we believe the odds of a deep drawdown 2023 are very low. Indeed, they’re low enough for us to say with high conviction that stocks will most likely rally big next year, even if a recession hits.
Growth Stocks Win Once the Recession Risk Passes
At the top of this note, we wrote that we’re very bullish on a certain group of stocks at the current moment. That group is hypergrowth tech stocks.
I know. That may sound counterintuitive. But follow me here…
We’ve identified a particular group of stocks that have been unnecessarily battered despite sporting rising earnings and revenues. And these stocks have a very good chance of snapping back to all-time highs.
See the chart below, which illustrates the strong positive correlation between S&P 500 price and sales. Numerically, this is a positive correlation of 0.88 — nearly perfectly correlated. You don’t get much more closely correlated than that in the real world.
Regardless of a recession, solid growth companies will continue to grow their revenues and earnings at a very healthy rate over the next several years.
In other words, their “blue lines” from the above chart will continue to move up and to the right. Eventually, their “red lines” — or their stock prices — will follow suit.
That’s why we’re very bullish on growth stocks today.
Their blue lines (revenues) continue to go higher and higher, while their red lines (stock prices) are dropping sharply. This is an irrational divergence that emerges during times of economic crisis. And it always resolves in a rapid convergence, wherein stock prices rally to catch up to revenues.
Beating a Recession With Growth Stocks
Despite the present market climate, now is not the time to freak out.
Remember: Crises create opportunities. In stocks, this has been the case forever. This time is not different.
And in the current crisis, the opportunity is particularly large in growth stocks. We fully believe that once this recession risk eases — and it will — certain growth stocks will rattle off 100%, 200%, and even 300%-plus gains.
The investment implication? It’s time to hunker down in the right growth stocks.
On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.