To The Moon

Rising interest rates, sky-high inflation, lackluster economic growth, pressure on corporate profit margins: It isn’t hard to come up with reasons to be bearish on the stock market right now—or see the S&P 500 down 20% and be full of doom and gloom.

But there are reasons to be optimistic, too. After the S&P 500 traded in bear-market territory and notched its seventh straight week of losses, now seems like a good time to bring them up.

For starters, a recession isn’t a done deal. Sky-high inflation and the Federal Reserve’s hawkish moves to bring it down, plus the long-running supply chain and Covid-19 drags on growth, are the best-known forces that risk tipping the U.S. and global economies into contraction. On the other hand, Americans have significant savings from the past two years that could help cushion the blow of those rising prices, and an ultra-strong job market is another positive for households. And while interest rates are certainly going up, they remain low by historical standards and won’t rise above neutral for some time.

“U.S. economic surprises remain in positive territory,” wrote RBC Capital Markets head of U.S. equity strategy Lori Calvasina. “High frequency economic indicators like dining, flying, back to work, and same store sales remain stable. Freight rates have come down sharply from their highs. Inflation expectations are retreating.”

That hasn’t stopped stocks from largely pricing in a recession since the start of the year. The S&P 500 pared its losses to end near break-even Friday, putting its loss to more than 18% from the index’s Jan. 3 record high. The Dow Jones Industrial Average has lost 15%, and the Nasdaq Composite has tumbled nearly 30%.

“Historically, the S&P 500 has fallen an average of 29% around recession (median of 24%),” wrote Truist co-CIO Keith Lerner on Friday. “With the S&P 500 currently showing a peak-to-trough decline of almost 19%, the market is effectively already pricing in a 60%-75% chance of recession based on the average and median.”

That means typical downside of another 7% to 13% if a recession does in fact arrive, according to Lerner. If it doesn’t, there’s a rally on its way.

“When equity market odds of recession have moved to current levels, 12-month forward returns have been binary,” wrote Keith Parker, head of U.S. equity strategy at UBS, earlier this week. “The S&P 500 fell by -9% on average when a recession materialized but rallied +12% if it did not.”

The entirety of the correction this year has been in the market’s valuation multiple, with analysts not pricing an earnings recession into their models. That could be a miscalculation, and suggest that estimates will have to decline. Or it could mean that the individual-company view is rosier than the macro picture.

“At face value, this year’s decline in the S&P 500 looks a bit unusual,” ​​wrote Thomas Mathews, markets economist at Capital Economics. “Previous large falls, such as in 2007-09 and 2020, have often come alongside big downward revisions to earnings expectations …By contrast, aggregate earnings forecasts for S&P 500 companies have been revised up this year, even as stock prices have tumbled.”

The S&P 500 now trades for less than 17 times its expected earnings over the next four quarters, down from nearly 22 times at the beginning of the year. The multiple is elevated due to the pricey Big Tech stocks at the top of the index, which is weighted by market value. The equal-weight S&P 500, meanwhile, trades for a forward price-to-earnings ratio of just over 14 times.

The optimist’s view is that’s a reasonable valuation that sets the market up for a potential rebound. Measures of investor sentiment, fund flows, and positioning have become significantly more bearish and negative as the market has sold off. Those contrarian indicators historically have been followed by rebounds. The past seven weeks have been painful, but the upshot is a much more attractive starting point for stock investors today.

The entry into a bear market has been the pivot point in the past. The S&P 500 has been higher one month later 83% of the time since 1950, according to Dow Jones Market Data, with an average gain of 3.7%. And a year after entering a bear market, returns have been positive 75% of the time—averaging 17%.

“Equities stand to recover if a recession doesn’t come through, given already substantial multiple de-rating, reduced positioning, and downbeat sentiment,” wrote Marko Kolanovic, J.P. Morgan’s chief global markets strategist.

It’s impossible to call a trough in real time, and a near-term bounce may be followed by further declines. But it isn’t all bad out there. And with stocks pricing in a near worst-case scenario, it wouldn’t take a lot of good news to get the market rising again.