- The stock market has further room to fall if the economy enters a recession, according to Goldman Sachs.
- The bank lowered its year-end S&P 500 price target for the third time this year to 4,300.
- Slower economic growth and higher-than-expected interest rates fueled Goldman's market call.
The S&P 500 is set to continue its decline to 3,600 if an economic recession materializes sometime over the next year, Goldman Sachs said in a note on Friday.
The bank lowered its year-end S&P 500 price target for the third time this year to 4,300, representing potential upside of 8% from current levels. Goldman's initial 2022 price target for the S&P 500 was 5,100, which was then cut to 4,900 in February. Its price target was subsequently cut again in March to 4,700.
Despite the subdued bullishness, Goldman still expects corporate earnings to grow 8% in 2022, which represents an increase from its prior forecast of 5%. Goldman's year-end price target for the stock market assumes no recession materializes and implies the price-to-earnings ratio for the broader market remains unchanged at 17x.
In a recession, which Goldman assigns a 35% probability of happening in the next two years, the bank expects the price-to-earnings valuation multiple on the S&P 500 to fall to 15x, driving much of the downside for stocks.
Much of Goldman's price target cut for the S&P 500 is centered around interest rates, which remain more elevated than the bank expected just a couple months ago. Goldman expects the yield on the 10-Year US Treasury to end 2022 around 3.3%, which is a big jump from its prior estimate of 2.7%. The 10-year US Treasury yield currently sits at 2.90%, and investors expect the Fed to raise the Fed funds rate by another 100 basis points this summer.
If the economy is able to avoid a recession, there still remains a downside scenario where surging interest rates take a bite out of valuations despite growing corporate earnings.
"If the Fed is forced to hike by more than our economists expect and real rates rise to 1%, similar to the peak reached during the last cycle in 2018, our macro model suggests that higher rates will more than offset the lower yield gap," Goldman said.
To navigate the rising uncertainty and various potential outcomes, Goldman recommends investors stick with high-margin growth stocks relative to their low margin peers.
"Growth stocks have derated sharply YTD as financial conditions have tightened. However, growth stocks with high margins currently trade at the same 5x enterprise value-to-sales multiple as low margin peers. We expect the multiples will diverge as investors prioritize profitability," Goldman said.