Investors all over are scratching their heads, trying to figure out where the market will head in 2023. Inflation has finally started to cool, but now the question is, how much of a hit will the economy take after the Federal Reserve's aggressive interest rate hikes this year?

Will there be a recession in 2023? If so, how severe will that recession be? Is unemployment about to skyrocket? How will the Fed's unwinding of its balance sheet impact markets? Or are concerns overblown, and is the Fed about to engineer a soft landing for the economy, in which inflation continues to come down and unemployment only rises modestly?

It's anyone's guess right now, but here's what could happen to the market in 2023: the good case, the base case, and the ugly.

Person looking at computer monitors.

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How bad could things get?

The way investors and analysts forecast the future price of the S&P 500, a benchmark index for the broader market, is similar to the way they would forecast the price of an individual stock. They try to calculate the combined earnings per share (EPS) of all the companies in the S&P 500 and then assign an earnings multiple for it to trade at. 

For instance, as of earlier this month, the median EPS price target for the S&P 500 in 2023 was $232.53. Currently, the S&P 500 trades slightly below 20x earnings, which is within the range it's been on average. So if this EPS consensus holds up, one could assume the S&P 500 would trade at 4,650 next year, which would be excellent considering what's going on.

However, many experts such as analysts at Barclays think forward EPS estimates like $232.53 and even multiples are too optimistic right now. Venu Krishna, Barclays' head of US equity strategy, said back in October:

Bottom line, earnings estimates remain too high, in our view, whether we have a recession or not. A recession will simply expedite the revision cycle and get us to the trough sooner. We think earnings disappointment is likely to drive the next leg lower in stocks.

At the time, Barclays estimated S&P 500 EPS of $210 in 2023 but assigned a lower earnings multiple. While inflation has started to cool, Krishna cautioned investors to "be careful what you wish for... Falling inflation will be bad for earnings" and has actually bolstered earnings more recently.

Barclays assigned a target of 3,675 for the S&P 500 next year, which is below current levels. The S&P 500 has only dropped in consecutive years occasionally, so this would not be good.

The base case

About a month ago, analysts at Morgan Stanley projected that the market would end the year at about 3,900, which is similar to where it's at now. However, Morgan Stanley expects the road to be bumpy.

Analysts at the bank have revised their EPS estimates for the S&P 500 down to $195 next year, which gets them to 3,900, assuming a 20x earnings multiple. Still, the analysts expect a challenging year of earnings to hammer markets in the first half of 2023, bringing the S&P 500 into the range of the low 3,000s.

But the team then expects 2024 to be a much better year for earnings, which will enable investors to reverse course in time to run the market back to 3,900, so they see a boring endpoint but a lot of volatility and excitement in between.

The bull case: The S&P 500 runs to 4,800

I don't think any analyst really expects this to happen sitting where we are today, but there is a path, according to Nicholas Colas, co-founder of DataTrek Research.

Colas tells investors to remember that it's all about pricing future earnings. Assuming a 17x or 18x forward multiple on earnings in 2024, analysts would have to think that the S&P 500 can generate EPS between $267 to $282 per share. That means the market's earnings would have to grow 23% over the next two years. The bulk of this would likely need to happen in 2024.

So how might this play out? Well, Colas said if a recession hits next year, the S&P 500 companies would need to maintain their earnings better than expected and eke out slight earnings growth next year. Then, the Fed would need to stop raising rates next year, which very well could happen, and begin cutting rates, which the Fed has not indicated at this point, leading to economic growth and much larger earnings growth in 2024.

The big kicker here, according to Colas, is that he doesn't see the S&P 500 hitting 4,800 without a recession because without it, he doesn't think companies will further reduce costs, which is needed to set up better earnings growth in 2024. I'd also point out that a recession would make the Fed more likely to cut rates next year.

As things stand today

While there is still a great deal of uncertainty in the environment, I am not expecting to see a replay of the Great Recession next year, as things stand now.

When you look at the strong labor market, where consumer loan losses are at compared to where they were pre-pandemic, and their savings, many consumers are starting from a position of strength, although there are definitely pockets of the population that have started to see their savings decline rapidly. Furthermore, the housing market looks in much better shape today than it did a decade ago.

Right now, I would expect the consumer to slow down and for prices to further stabilize, which could hurt earnings. But I wouldn't expect a severe recession, which is a double-edged sword because while it's better for the economy, it might not drive the Fed to cut rates or create enough earnings growth to drive the S&P 500 deeper into the 4,000s.

That's why I am currently taking Morgan Stanley's view that the S&P 500 is likely to end next year around current levels and potentially sneak into the 4,000s.