Welcome to RBC’s Markets in Motion podcast, recorded March 3rd, 2025. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets.
Please listen to the end of this podcast for important disclaimers.
The big things you need to know: First, we review our basic framework for thinking about drawdowns in US equities, a topic that’s been coming up in client meetings over the past few weeks, as investor uncertainty regarding the economy has increased. Second, we have refreshed the math behind our YE 2025 bear case of 5,775, specifically our valuation/EPS stress test. Third, we run through our latest updates on the vibes breakdown in the US, where investor sentiment has plunged to crisis lows on one key metric. Fourth, some of our work suggests opportunity is opening up in Small Caps, though we think it’s too early to go overweight.
If you’d like to hear more, here’s another five minutes.
Starting with Takeaway #1: Our Framework for Thinking About Downside Risks To US Equities When Uncertainty Mounts
- For many investors we’ve been speaking with, uncertainty and anxiety have increased over the past few weeks. The disruption in Washington, health of the consumer and health of the labor market have been in focus, with lower 10 year-yields and renewed discussions about cuts from the Fed later this year providing some comfort. For many weeks, most US investors we’ve spoken with have assumed tariffs would be a negotiating tool rather than a long-lasting reality, but in last week’s meetings several investors expressed to us their worry that this idea had become too consensus.
- Some investors from completely different corners of the US equity market, with completely different investment styles, have asked us a similar question in recent weeks – “how do we think about potential downside risks to the US equity market?” Some have simply been thinking about where a “put” might be in the short-term. Others have been thinking about how US equities respond generally to big uncertainties. Here’s what we’ve been saying about the four tiers of fear as we’ve started to call them
- Tier 1 - garden variety pullbacks (drawdowns of 5-10% from peak, based on daily close prices). Since 2022 the US equity market has experienced a handful of these. The worst came in the fall of 2023 as 10-year Treasury yields surged, and the S&P 500 fell 10.3%. Net bullishness more than one standard deviation above the long-term average on the weekly AAII investor survey has helped to identify their onset, a milestone last achieved in October 2024 – which has kept us on guard for one of these drawdowns. From the recent peak, this kind of decline would take the index to the 5,500-5,800 range, and we see the low end of that range as the first battleground where the US equity market is likely to display some resilience. We think our YE S&P 500 price target of 6,600 can absorb a pullback in this range, but if a drawdown of more than 10% occurs, our 6,600 target seems unrealistic.
- Tier 2 - growth scares (14-20% drawdowns). Investor confidence in the aftermath of the Great Financial Crisis was extremely low for an extended of time, and from 2010 to 2018, there were four of these: the European debt crisis, the US debt downgrade, the industrial downturn of 2015-2016 (when consumer resiliency helped the US avert an outright recession) and 2018 (when the China trade war and Fed fears took the S&P 500 index down almost 20%). What these all had in common was that investors suddenly became very fearful that a systemic issue or recession was unfolding, but it ultimately failed to materialize. The risk of this kind of drawdown has moved up recently in our view.
- Tier 3 – recessions and wars (roughly 25-33% drawdowns). When growth fears turn out to be legitimate, the S&P 500 tends to lose around a quarter to a third of its value. War related drawdowns in recent decades have been similar.
- Tier 4 - major modern crises (roughly 50% drawdown). We started our career in the early days of one of these, the Tech bubble unwind of the early 2000’s. That drawdown totaled 49% through the October 2002 low. The GFC drop was worse, with a 57% peak to trough drop.
- It was the GFC that helped us develop the list of things we use to look for bottoms in any tier of US equity market fear: sentiment surveys like AAII (moves 1 and 2 standard deviations below the long-term average tend to be buy signals), EPS revisions (we look for improving rates of change off trough levels), and Small Cap P/E’s are some of our go to ones (since 1990’s the R2000 forward P/E usually bottoms in the 11-13x range or slightly below average).
Moving on to Takeaway #2: Refreshing The Math That Goes Into Our Bear Case
- Back in November 2024, when we issued our YE 2025 S&P 500 price target of 6,600, we also mapped out a potential bear case for the S&P 500 for a year-end level of 5,775. While we haven’t made any changes to that 5,775 bear case, we have revised our stress test on one of the models that goes into our bear case that’s worth mentioning.
- Specifically, our valuation/earnings stress test is now baking in flat EPS in 2025 vs. 2024 (similar to the lack of movement in the annual numbers from 2014-2016 around the industrial recession, previously we were using our base case forecast of $271 in our stress testing) and a different inflation/interest rate scenario (now, we have sticky inflation at 2.5% on PCE, several Fed cuts, and 10-year yields at 3.5% whereas before we were baking in higher inflation. Fed hikes, and 10-year yields at 5%).
- Both the old and new valuation/earnings stress tests point to fair value for the S&P 500 at year end slightly above 5,600. The improvement in the multiple in our new stress test is offset by the EPS degradation that we assumed a growth scare might lead to.
Next, Takeaway #3: A Vibes Update…
Strong post election vibes were an important part of the bullish consensus on 2025 for US equities which has come under pressure. The various categories of vibes that we’ve been monitoring have generally been weakening or, in the case of corporate vibes, have been dented by policy uncertainty. Here are some of the latest developments:
- Investor vibes have continued to weaken and are back to crisis lows on some metrics. Bears in the weekly AAII survey (a weekly gauge of individual investor sentiment) surged to more than 60% last week, on par with levels seen in September 2022, and a little shy of the 70% level in place in March 2009 as equity markets hit their GFC lows. October 1990 (67%, a recession year) and February 2003 (58%, the end of a multi-year period of recession, war and extreme angst) were other periods that saw extreme bears in this range.
- With last week’s move, net bulls fell to -41.5%, taking the four-week average to -20.3%. The four-week average is nearly two standard deviations below the long-term average, a level last seen in October 2022.
- We also got more evidence of weakening consumer vibes. Consumer confidence fell and missed expectations in the Conference Board survey released last week, and is now near the low end of its post COVID range.
- The most interesting thing to us was that consumers’ expectations of where the job market is headed has deteriorated, echoing what we saw in the prior week’s CEO confidence survey. These releases have struck a nerve with some of the investors we’ve spoken to. Several mentioned noticing more layoff announcements by public companies, something we’ve also observed.
Wrapping up with Takeaway #4 on Small Caps….
- Small Caps have gotten hit hard recently as economic growth fears have escalated. On performance, the ratio of the Russell 2000 relative to the S&P 500 is essentially back to it’s 2024 low.
- Meanwhile, the Russell 2000 forward P/E has fallen to 15x, slightly below it’s long-term average. This latter data point is particularly interesting to us because Small Cap P/E’s often bottomed out slightly below average from 2015-2019.
- We’ve been neutral Small Cap relative to Large Cap and think it’s premature to turn overweight. We’d like to see CFTC positioning in US equity futures get hit harder before believing the froth is completely out of this corner of the equity market, and think we are still in the early days of ratcheting down economic expectations.
That’s all for now. Thanks for listening. And be sure to reach out to your RBC representative with any questions.