According to Goldman Sachs Research, the bear market in stock markets is expected to intensify before giving way to more promising signals throughout 2023.
The MSCI All Country World index of global stocks is down about 19% this year. While stocks have rallied slightly since the summer, our strategists expect higher volatility and declines during this bear market before hitting a low later in 2023. They expect interest rates to peak and growth deteriorate economy stabilizes before a sustained rally in equities gets underway.
The fundamentals driving the global equity market have changed dramatically, wrote Peter Oppenheimer, chief global equity strategist and head of macro research in Europe. In the team’s Outlook 2023, he pointed out that, in a reversal from previous years, the cost of capital has risen sharply, hitting the valuations of fast-growing companies whose profits are expected to materialize in the future. Earnings of big tech companies fell short of analysts’ expectations.
Higher interest rates and commodity prices have made high-quality companies with dependent profits and free cash flow more attractive. “There has been something of a relative reversal of fortunes between traditional incumbents and digital new entrants in many industries,” our strategists wrote. They favor companies with high dividends, strong balance sheets and high margins.
At the same time, investors may face a persistent bear market. There are two main types: “cyclical” ones driven by a slowing economy and rising interest rates and “structural” ones driven by a shock like a financial bubble or disaster, according to Goldman Sachs Research. This downturn is of the cyclical variety, typically lasting 26 months and taking 50 months to recover. Stocks typically fall 30% and are hit by brief rallies before the market bottoms out in these cycles.
There are several key reasons our strategists think shares could fall further. While valuations have declined this year, they have come off a very high peak amid extremely low interest rates. While many stock markets around the world trade at low valuations, US stocks are not: US stock valuations are still at levels consistent with the peak of the tech bubble in the late 1990s.
Some of the differences in valuations are likely explained by better expectations for economic growth in the US and a stock market with a different mix of companies. But even with that in mind, GS Research says it’s hard to justify why the US market is in line with its 20-year average. This is especially true when the margins of big tech companies are under pressure, resulting in job cuts and falling investment. And meanwhile, yields on government and corporate bonds have risen enough to become a competitive alternative to equities.
Historically, the best time to buy stocks is when economic growth is weak but nearing stabilization. But while expansion prospects should improve by the end of the year, that hasn’t happened yet. “Timing is everything,” according to the Goldman Sachs Research strategist. “A weak economy that is still deteriorating is very different from an economy that is less deteriorating.”
Goldman Sachs Research predicts recessions in Europe, while the US narrowly avoids a recession. But even if the world’s largest economy manages to continue growing, our equity strategists say there’s a strong risk investors will price in a greater possibility of a US recession before stocks hit bottom. Their base case is that earnings are stable in 2023.
The spike in interest rates is likely to be bullish for equities. However, our strategists believe bond yields still have room to rise, in part because US policymakers are focused on maintaining tighter financial conditions to help contain inflation. Furthermore, it is not yet clear how long rates will remain high before central banks are ready to lower borrowing costs. Goldman Sachs economists do not expect any rate cuts from the US Federal Reserve in 2023.
Investor positioning, meanwhile, signals that the market has not yet reached its bottom. By some measures, investors have become more defensive and repositioned their portfolios to take less risk, but flows into equity funds are still robust, especially in the U.S. Our strategists expect to see more signs that investors have caved in to the bear market before stocks hit bottom.
The global stock market’s “hopeful” phase could begin later this year, according to Goldman Sachs Research. These recoveries usually start during recessions when valuations rise. Historically, it has been better to invest in stocks immediately after the trough than just before: 12-month average returns are higher one month after the trough than they were one month before. “For this reason, we believe it is too early to position for a potential bull market transition,” Goldman Sachs strategists wrote.