If you’ve been wondering how quickly stocks might return to their most recent peak, Ray Dalio and his hedge fund research team have a message for you: slow down. Stocks still have further to fall and they’ll do so, they say, as the US economy slides into a recession, in 2023 or 2024. Here’s how this might all play out…

What’s their view then?

Researchers at Dalio’s Bridgewater Associates, the world’s biggest hedge fund, say stocks tend to fall in two stages when interest rates rise. And the first stage may not be done playing out just yet…

Stage 1: valuations drop.

The more interest rates rise, the more attractive cash becomes relative to risky assets like stocks. Think about it: with so many unknowns on the horizon, doesn’t earning a virtually risk-free 3.5% return on your cash sound pretty tempting? You’d hold stocks only if you expected them to deliver returns that more than compensate you for their higher risks – and for the higher cost of opportunity of holding cash. Put differently, you’d only hold them if they trade at a discount, meaning that their valuations fall to a level that makes them attractive again.

That’s exactly what’s been happening, with a fall in stock valuations responsible for most of the price correction so far. But here’s the thing: while stocks are less expensive than they were a few months ago, they’re nowhere near bargain levels. And the higher interest rates rise, the more valuations – and stock prices – will have to fall to keep them competitive relative to cash. With the Fed still hiking rates aggressively, stage 1 is probably still playing out, and a further dip in stock valuations is a very real risk.

Stage 2: earnings weaken.

While the valuation dynamic we explained above has been the main driver of stocks’ recent returns, another one might play an even bigger role in the future: a slowdown in earnings growth. Research from Bridgewater shows that this may be the make-or-break factor in whether stocks experience just a small correction or something worse. If the economy and earnings drop only modestly over the next few months, then stocks probably won’t fall much further. But if earnings take a big hit, a 2008-style catastrophic crash becomes a distinct possibility.

The make-or-break factor for stocks will be earnings. Source: Bridgewater

Right now, investors are confidently betting on a modest drop. Seeing the economy as “down but not out”, they’re optimistic that companies will be able to maintain their high margins and earnings. Bridgewater warns that may be misguided. That’s because, as we explained here, it takes time – a few quarters typically – for the effects of higher interest rates to feed through the economy and impact companies’ earnings. Put simply, rising rates generally pummel earnings pretty hard – and the higher interest rates, the bigger the punch – but it doesn’t happen immediately.

How much lower can stocks go?

Based on this analysis, the outlook for stocks now depends on two things: how high interest rates go, and how companies’ profits cope with those higher rates.

Right now, neither is looking particularly positive. With inflation still high, the Fed has just approved its third-straight “jumbo” interest rate hike and says more are on the way. As we explained earlier, that’s a negative for stock valuations. Meanwhile, leading indicators of economic activity continue to show signs of weakness, suggesting that companies’ profits might be about to crumble. That’d be rough for stocks, which have historically experienced their sharpest losses when rates were rising, and earnings falling.

Stocks experienced their sharpest losses when rates rose and earnings fell. Source: Bridgewater

As for the master hedge-funder himself, Dalio estimated that interest rates reaching 4.5% would likely be enough to send stocks another 30% lower. Given how optimistic investors are about future earnings, I’d argue he’s probably right.

So what’s the opportunity?

The bright side about interest rates rising is that it’s becoming a lot easier (and more profitable) for investors to stay on the sidelines. By keeping a good-sized portion of your portfolio in US dollar cash or short-term bonds, you not only preserve your financial and emotional capital, but you also get paid (up to 4.5%) to do so. And, if stocks do crash in an epic way, you’ll be able to take advantage of a once-in-a-decade entry point. At the same time, consider gradually building your stock position using dollar-cost averaging, to take advantage of opportunities that come along. Timing is notoriously hard in investing – and there’s a decent chance that even a star like Dalio could get it all wrong. But, if you’re cautious, you’ll find some wins along the way…