Recapping our views on what the escalations in the Middle East mean for US equities.
It remains our belief that the longer and broader the conflict becomes, the more challenging it is likely to be for US equities. These escalations come at a tricky time, as the S&P 500 has looked fairly or even a bit overvalued to us from a fundamental perspective, but with more room to run from a sentiment perspective.
The three main concerns we’ve had are:
- The tendency for valuations to compress when uncertainty regarding national security rises.
- The potential for the event to derail the recovery in investor, small business, and consumer sentiment that has been underway - and to deepen the deterioration in corporate sentiment that has persisted.
- Upside risk to oil prices. Lack of conviction that oil supply is at risk has, in part, kept stocks calm, but this thesis may soon be tested.
Zooming out, the fog in the US equity market outlook - which had dissipated a bit from a tariff perspective since mid May - has gotten much denser in the past week due to geopolitics. In thinking about potential downside, we rely on our “four tiers of fear framework” for US equity market drawdowns, which helped us navigate tariffs as conditions evolved in March and April. It reminds us that a 5-10% S&P 500 drawdown is a good starting point to assess potential downside risk when confronted with any major uncertainty and we think that’s a good starting point for thinking about downside risk today, especially since we’ve seen these kinds of reactions in stocks since 2023 to earlier episodes in current conflict.
If stocks sell off, it will be important to monitor the risk of a retest of the April 2025 low - which was a textbook tier 2 growth scare low - since our valuation stress test that takes inflation back to 4% points to possible downside in the S&P 500 to the 4800-5200 range, using various flavors of earnings. Besides an inflation spike, sentiment erosion could spark this if recession fears start to percolate again. These risk scenarios would likely take some time to play out, potentially allowing the stock market to be patient in how it trades.
