What Goldman’s Recession Manual Is Telling Us About This Recession

What Goldman’s Recession Manual Is Telling Us About This Recession
Stéphane Renevier, CFA

over 1 year ago4 mins

  • The Goldman Sachs recession manual tells us it’s too early to confidently call a bottom in the stock market. After all, share prices haven’t fallen far enough, they haven’t been down for long enough, earnings are way too high, and valuations aren’t low enough yet.

  • Since the stock market tends to bottom when the economy has already entered recession and the outlook is the bleakest, you may want to wait a bit longer before buying the dip.

  • In the meantime, invest conservatively. Hold a diversified portfolio of high-quality defensive stocks, commodities, and even Treasury bonds. And if you want to add assets with more attractive risk-reward profiles, China looks like a decent bet.

The Goldman Sachs recession manual tells us it’s too early to confidently call a bottom in the stock market. After all, share prices haven’t fallen far enough, they haven’t been down for long enough, earnings are way too high, and valuations aren’t low enough yet.

Since the stock market tends to bottom when the economy has already entered recession and the outlook is the bleakest, you may want to wait a bit longer before buying the dip.

In the meantime, invest conservatively. Hold a diversified portfolio of high-quality defensive stocks, commodities, and even Treasury bonds. And if you want to add assets with more attractive risk-reward profiles, China looks like a decent bet.

Mentioned in story

Goldman Sachs is famous for its recession manual: a deep-dive handbook on past recessions and what brought them about. And now, with every economist and their dog predicting that the US is headed for a dramatic slowdown, it’s the perfect time to pick up the manual, dig into the three metrics it focuses on, and see what it can tell us about what comes next.

Metric #1: Share prices

In the past 12 recessions, the median drop of the S&P 500 – measured from peak to trough – was 24%. That means they dropped less than that on six occasions, and rose by more on the other six. But when they dropped more, they dropped a lot more: 48% in 1973, 49% in 2001, and 57% in 2008. It took a while for prices to go from peak to trough too: as long as 30 months in 2001.

Peak to trough price declines around recessions. Source: Goldman Sachs
Peak to trough price declines around recessions. Source: Goldman Sachs

Today, the S&P 500 is down around 20% from its peak, and it’s been there for six months. That’s both a less severe fall and one that’s shorter in duration than the usual recession-era bear market. If stocks were to experience a loss of 50% like they have in the past, they would fall another 37% drop from where they are now. So while prices have already dropped as far as they did in some past recessions, history suggests there could be a lot further to fall.

Metric #2: Company profits

Past recessions have seen stocks’ earnings per share (EPS) drop by a median of 13%, but with quite a bit of variation from recession to recession. Still, the valuation metric has fallen by more than 20% in three of the last four – including a stunning 45% drop in 2008.

Peak to trough earnings declines around recessions. Source: Goldman Sachs
Peak to trough earnings declines around recessions. Source: Goldman Sachs

Surprisingly enough, the current backdrop of rising interest rates, high inflation, and a 20% collapse in stock prices hasn’t impacted analysts’ forecasts of future profits. They’re still expecting them to keep growing. But more and more companies are lowering their own profit forecasts, which could force analysts to revise down their own estimates.

History suggests that this would bring the stock market’s overall EPS down: Goldman points out that recessions have been preceded by a drop in consensus EPS estimates of between 6% and 18% in the prior six months. And since profits are the only thing holding up the stock market right now, that could be catastrophic…

Metric #3: Stock valuations

Since the 1980s, the S&P 500 forward price-to-earnings (PE) ratio has fallen by a median of 21% from its high to the start of a recession. But the total peak-to-trough in forward P/E has sometimes been much bigger: the forward P/E fell by around 50% in 2001, for instance, as the market continued to slip even after the recession had ended.

Historical forward P/E ratio. Source: Bloomberg
Historical forward P/E ratio. Source: Bloomberg

Today, the S&P 500’s forward P/E has dropped 30% from its high, suggesting that it’s already past the “normal” recession drop. Then again, it’s worth noting that the peak it started from was much higher than normal, meaning the drop could’ve just erased post-Covid excesses. In other words, companies are a lot cheaper now than they were a few months ago, but they certainly aren’t cheap.

So what does that tell us about what’s next?

If history’s any guide, we can’t confidently say that share prices have bottomed yet: share prices haven’t fallen far enough, they haven’t been down for long enough, profits are way too high, and valuations aren’t low enough.

Now, of course, all of the analysis above assumes that the US economy will indeed fall into a recession, which might not happen. If inflation cools down enough for the Federal Reserve to take its foot off the rate-hike pedal, the economy just might improve and we can relax. That’s possible, just not likely.

Which brings us to how to time the recession. The stock market has historically peaked around eight months before the start of a recession, and it’s started to rebound around six months after the recession started.

Sequence of inflection points around recessions. Source: Goldman Sachs
Sequence of inflection points around recessions. Source: Goldman Sachs

The important takeaway here isn’t that a recession will definitely strike, but that you won’t want to buy the dip just yet if you agree that a recession is likely.

If you’re wondering when to start buying… well, there’s no exact rule. But Goldman’s recession manual shows that the bottom of the market typically happens within weeks of when the unemployment numbers hit their highest. Employment is one of the last dominoes to fall in the rate hiking cycle, coming after company profits have started to fall. It might be worth waiting for the recession to be in full bloom before buying the dip, and buying when the economy – and unemployment in particular – look the weakest. Put another way: when everyone’s thrown the towel, that’s the time to buy.

In the meantime, stay patient and invest conservatively. Make sure you’re holding a diversified portfolio of stocks, commodities, and even US government bonds. Within your stock allocation, make sure to hold high-quality shares in defensive industries, and diversify into regions with attractive risk-reward profiles like China.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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