Stock Markets Need a Reality Check

Investors should be cautious and disciplined these days—the economy is slowing, the stock market is expensive, and with inflation ebbing, the Federal Reserve (Fed) will cut interest rates further. History tells us that a recession is possible in this scenario, but market pricing suggests a reacceleration of growth.

So, which is it?

Back in January, AMG predicted an economic slowdown induced by higher interest rates and forecast that as the Fed cut rates, growth would gradually regain steam. A consensus of market analysts today has an even rosier outlook, anticipating a more robust pickup in which this slowdown is short-lived as inflation is completely tamed, interest rates are cut and stocks rocket to record highs.

One of the major disparities between the market consensus and AMG is the earnings forecast for equities. Wall Street analysts suggest a rapid acceleration in earnings growth tied to a strong economy and growth in capital expenditures related to AI. This prediction anticipates that the economy accelerates from here, rather than decelerates. AMG believes earnings growth will wane to a below-trend pace (trend growth being 7-8% long-term) as the economy continues slowing down before picking up in late 2025 or early 2026.

Stock market valuations today reflect Wall Street’s rosier outlook, with price-to-earnings ratios based on next year’s elevated earnings expectations. This is likely to change this autumn if the slowdown evolves as AMG anticipates. Investors should expect an environment of volatility, with the market possibly correcting 15-20% from its recent peak. Such a large correction would be a non-recession bear market, implying an S&P 500 level closer to 4,600 than the over 5,700-5,800 level reached recently.

Bottom Line: Diversification makes the most sense. Profitable small- and mid-cap stocks and foreign stocks are relatively inexpensive, while dividend-oriented stocks are likely to cushion the potential downside. All three market segments offer attractive risk-reward on a multi-year investment horizon.