The market is failing to price in the likelihood of a recession that would push stocks down by about 30%, according to a study by The Leuthold Group summarized by Bloomberg. Leuthold compared previous highs and lows in S&P 500 valuations based on EPS calculated under GAAP accounting rules. They found that the S&P 500 now trades at roughly 19.4 times earnings, a valuation within the top 10% of historical measurements.

“If we do stumble into recession over the next year, which I think is likely, I think we’ll see below 2,000s on the S&P,” as Doug Ramsey, chief investment officer (CIO) of Leuthold Weeden Capital Management, told Bloomberg. “It’s very easy to get there. We don’t need to assume that you go back to old bear market lows," he added.

Significance for Investors

The current valuation multiples of 19.4 for the S&P 500 and 24.4 for the Nasdaq 100 are reasonable only during economic expansions, especially when interest rates are as low as they are today, Bloomberg observes. When the last 12 bear markets during the past 70 years hit their respective bottoms, the valuation multiple has ranged from 5.6 to 14.4, with the latter figure coming at the low point of the dotcom crash.

Harris Kupperman, the president of Praetorian Capital Management and CEO of Mongolian Growth Group, is among those concerned about valuations. "These things literally have no economic rationale to exist [except] for the fact that liquidity has been pushed through the system, and people keep buying shares because they believe that there's some other sucker who's even dumber than they are," Kupperman told Business Insider in an extensive interview. "I've been through 2 crashes in my life, and I think this is the third one," he added.

Kupperman believes that the Federal Reserve has added to the risks. "When you push liquidity through the system like they have the last ten years, you create a giant bubble," he said. Blaming the Fed for creating what he calls a "Ponzi sector," he elaborated: "Ponzi stocks are things like WeWork or Tesla [Inc. (TSLA)] or other blatant frauds. The Ponzi sector being all the companies that have no chance of ever earning a profit, yet they continue to grow revenue."

Goldman Sachs sees a mixed U.S. economic picture, with the ISM Manufacturing Index falling in both August and September, reaching its lowest level since March 2009. However, they note that job growth remains strong, with 136,000 new jobs in September pushing the unemployment rate down to a 50-year low of 3.5%, per their current US Weekly Kickstart report. Morgan Stanley observes that the U.S. manufacturing sector may be headed toward recession, but services remain "robust" due to strong consumer spending, per their current Weekly Warm Up report.

Looking Ahead

The Federal Reserve Bank of New York estimates that a recession in the U.S. has almost a 40% likelihood of beginning in the next 12 months, the highest percentage during the current bull market, which began in March 2009, per Bloomberg. Nonetheless, the same article notes, most strategists and economists do not expect the next U.S. economic contraction to be nearly as severe as the last one, the Great Recession of 2007 to 2009, which overlapped the financial crisis of 2008. Moreover, the lower interest rates of today may support somewhat higher stock valuations than existed during the depths of the last bear market, Bloomberg adds.