Here's why a recession is essential to the bullish outlook for the stock market in 2023
- A recession will be necessary to drive upside in the stock market, according to DataTrek Research.
- That's because a shallow recession could drive aggressive cost cutting at companies, helping boost profits in 2024.
- "It is harder to make the case for S&P 4,800 if we do not see a US/global recession next year," DataTrek said.
A bullish outcome in the stock market next year is unlikely unless an economic recession materializes, DataTrek Research said in a Thursday note.
"The easiest way to defend a 4,800 1-year price target on the S&P 500 is to assume a 'growth recession' in 2023 and a subsequent earnings recovery in 2024," DataTrek co-founder Nicholas Colas said in a Thursday note.
And a recession is very possible next year, according to Colas, given the recent period of high interest rates and elevated inflation. But that means a recession shouldn't be a surprise to companies, and that they can properly plan and come out stronger on the other side of an economic downturn by being more profitable.
"When the slowdown does come, sometime in 2023, companies should be able to adjust their cost structures to keep profitability at current levels or even improve slightly. That's how you get 5% earnings growth next year," Colas said.
And then from there, it's not unreasonable to expect that the broader economy will start seeing more tailwinds than headwinds, which would give investors confidence that corporate earnings can hold up, according to the note.
"At some point in 2023, inflation will have declined enough that central banks will be able to start cutting rates. This will spur an economic expansion in 2024. Corporate profits will reaccelerate quickly because cost structures will be leaner," Colas said.
That means it's harder to make the case for the S&P 500 to rise 20% in 2023, as some expect, if a global or US-based recession fails to materialize.
"If we manage to avoid an economic contraction next year then there will be little impetus for companies to right-size their cost structures. This, in turn, will limit earnings leverage in 2024. If markets can't tell a decent story about earnings growth in the out year, they will be less likely to put a healthy multiple on future earnings in 2023," Colas said.
"It is a lot easier to be bullish if you include a mild recession into a market outlook since companies will respond as they always do: by cutting costs," Colas said.
Ultimately, DataTrek is more bearish on the stock market in 2023 and doesn't expect a 20% rise, but "understanding that uber-bullish case is useful in terms of handicapping more-likely scenarios," Colas said.
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