Stocks could soar 10% by mid-2023, but investors should expect a decade of flat markets after that, major investment bank says

“There is a window for a first-half 2023 rally,” Bannister wrote in a Monday research note, arguing the S&P 500 index could jump roughly 10% to 4300 by mid-June.

He believes the U.S. economy will avoid a recession in the first half of 2023 and achieve something that “may resemble a ‘soft landing,’” despite the potential for a “major slowdown” in corporate earnings. 

He also claimed that inflation will fall quickly over the next few months, leading the Federal Reserve to pause its interest rate hikes in the second quarter. The Fed raised interest rates seven times in 2022, hoping to slow consumer price increases that reached a four-decade high of 9.1% during the summer. The higher rates have weighed on stock prices, as companies face rising debt costs and a slowing economy.

But by the third quarter, Bannister predicts that year-over-year inflation will tumble to just 3.5% as the Fed’s rate hikes continue to impact the economy. 

“While that is still above the Fed’s ‘2%’ goal…it would likely support a mid-2023 Fed rate pause,” he wrote, arguing that this pause in rate hikes should benefit stocks in the near term. 

But Bannister went on to warn that unemployment will rise by the third quarter, increasing the likelihood of an “official” U.S. recession in the second half of the year that strips away any previous stock market gains.

“2023 may be a year of two halves, with the S&P 500 peaking mid-2023,” Bannister wrote. “We may only be halfway through a two-year S&P 500 ‘super-bear’ market.”

A warning for stock market investors

Bannister made it clear that his prediction of a first half rally in stocks depends on lower interest rates. If inflation doesn’t fall as sharply as he suspects, the Fed will be forced to continue raising interest rates, which could force the S&P 500 down another 15%, to roughly 3300.

And beyond 2023, Bannister warned about a coming decade of low investor returns. Interest rates will hover near normal historical levels in coming years—as opposed to the past decade, when they were often stuck near-zero, he said. That, coupled with “decades of strong commodity price growth” that keeps inflation elevated, will force investors to value companies more conservatively over the next decade.

Bannister said he believes the earnings per share (EPS) of S&P 500 companies will double by 2031, but at the same time, the index’s price-to-earnings ratio—a metric used to value corporations by their earnings—will be cut in half. That will leave the S&P 500 “about flat in 2031 versus the December 2021 peak level,” he wrote. 

Bannister pointed to Yale economics professor Robert Shiller’s cyclically-adjusted price-to-earnings (CAPE) ratio, which is based on average inflation-adjusted earnings over the past 10 years, to illustrate just how overvalued many firms on the S&P 500 are today.

The CAPE ratio for the S&P 500 is currently 28, but it could be cut in half to just 14 in Bannister’s forecasted “10-year secular bear market.” He cautioned there could be a lot of volatility for investors during that process.

“Unless the Fed seeks to bludgeon markets, a halving of the P/E is typically a decade-long process and is not linear,” Bannister explained.

For stock market investors, that means it’s important not to get too excited if there is a rally in the first half of this year. 

“Any near-term rally view, including ours, is just a trade because the gross overvaluation of 2021 likely locked in a weak 2020s decade,” Bannister said.