Stocks face more downside risk even after a massive sell-off as earnings come under pressure and investors eye alternatives, Goldman Sachs says

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Stocks face more downside risk even after a massive sell-off as earnings come under pressure and investors eye alternatives, Goldman Sachs says
Mark Lennihan/AP
  • Stocks could have more room to fall, even after the recent sell-off, Goldman Sachs analysts wrote Thursday.
  • For now, equities are only pricing in a mild recession as valuations drop amid rising rates and a more hawkish Fed.
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Stocks still face an elevated risk of further downside, even after slipping into bear market territory, according to Goldman Sachs.

For now, equities are only pricing in a mild recession as valuations fall amid rising rates and a more hawkish Federal Reserve, analysts said in Thursday note. But macroeconomic headwinds are likely to turn earnings revisions negative in the second half of the year, they warned.

"Profit margins across markets are still elevated and some normalisation would result in negative earnings revisions – cyclically adjusted valuations like S&P 500 Shiller P/Es remain relatively elevated, especially in a long-run context," according to the note.

Despite the S&P 500 already sinking about 21% in the first six months of the year, marking its worst first half since 1970, Goldman estimated the index could hit 3,600 in a recession scenario.

For now, the bank's economists see a 30% chance of a US recession in the next year and a roughly 50% probability over the next two years.

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Still, even with the rising likelihood of a recession, analysts don't expect one to be deep or prolonged as the global economy "is not facing major imbalances."

But as the Fed raises rates to fight inflation, pushing yields higher, stocks will no longer enjoy the so-called TINA trade, when "there is no alternative" for getting a return.

Goldman noted that unless bond yields start to decline, stock prices could drop further, as investors are no longer stuck with choosing between equities and bonds with ultra-low rates.

"With sticky inflation and rising yields, investors are facing TARA (There Is A Reasonable Alternative) and as central banks are busy fighting inflation they could struggle to buffer the business cycle," the analysts said.

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