High stock valuations suggest investors think the US economy will avoid recession, but expecting more equity gains is a stretch, Barclays says

• The S&P 500 is up about 18% from its October lows, getting close to reach bull-market status.

• But Barclays says “the bull case for equities, like valuations, is still a stretch.”

• Earnings estimates are still high for an economy that’s unlikely to skirt a recession, the bank says.

The benchmark for the largest stocks in the US is knocking on the door of a bull market, hoisted from lows in part by investors optimistic about prospects for the economy. But Barclays says the case for a sustainable new bear market is a stretch for now.

The S&P 500 has crept up nearly 18% since hitting a low of 3,491.58 in October when investors shoved the index further into a bear market, shaken largely by the Federal Reserve’s rapid rate hikes. It’s gained more than 7% in 2023, fronted by a surge in the communications services, tech and consumer discretionary sectors.

“Equities have thus far leapfrogged an improbable list of pitfalls, and every cleared hurdle may serve as another reason to risk buying a head fake if it means not missing the first step,” Venu Krishna, head of US equities strategy at Barclays, wrote to clients in a research note published Monday.

“However, we think we still have a ways to go before seeing the trough,” he continued. “Valuations can remain irrational for a time but earnings cannot, and if the history of recessionary bear markets (particularly high-inflationary ones) is a guide, both sides of the P/E multiple remain exposed to asymmetric downside risks.”

Stocks have pushed through stubborn inflation, the Fed’s aggressive policy tightening, and — so far — the banking crisis that erupted out of last month’s collapse of Silicon Valley Bank and Signature Bank. That sparked an indiscriminate flight to quality and market breadth deterioration, said Krishna.

But Barclays sees valuations as “too optimistic” relative to its base case for a shallow recession and $200 in per-share earnings collectively for S&P 500 companies in 2023.

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There’s a bull case to be made considering the S&P 500 is trading greater than 18.5 times consensus of 2023 per-share earnings and roughly 21 times the estimate held at Barclays, it said.

Investors are looking through an earnings contraction this year to an implied rebound in 2024 and positioning is making it “far more punitive” to be late than early. Mutual funds and hedge funds, for example, were caught sharply underweight the tech sector ahead of the recent flight-to-quality moves.

But with a recession looming, Barclays said it’s confident the majority of cuts in next twelve months earnings estimates are still on the way.

Meanwhile, the market is still pricing in a “no landing” scenario, an outlook that sees the Fed bringing inflation to or near its 2% target while the economy skirts a recession and recovers strongly next year.

“This is the outcome that best supports current consensus, and we just don’t see it,” said Krishna.

“Ultimately, we think the bull case for equities, like valuations, is still a stretch,” he said.

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