If you're looking for a view of where equity markets are headed based on a blend of strong academic research and study of how past Federal Reserve policy and macro trends historically influence prices, you can't do better than listening to Chris Brightman. He's CEO and chief investment officer at Research Affiliates, a firm that designs investment strategies for $169 billion in mutual funds and ETFs offered by such firms as Charles Schwab and PIMCO. Ever since the S&P and NASDAQ started setting fresh records in mid-2000, Brightman and Research Affiliates founder Rob Arnott have been warning that inflated price-to-earnings multiples on top of a profit bubble, against the backdrop of a classic frenzy, made stocks substantially overpriced. In a debate with Cathie Wood last September, Arnott charged that the Ark Invest chief was amassing hot players at bubble valuations, and profiting from runaway momentum that would eventually ebb, causing steep declines. We now know who won that duel.

I interviewed Brightman at length on his outlook for equity prices and the economy. In summary, he believes the chances of a recession are "better than 50-50. We could round those odds to about 60%."

He foresees four possible scenarios for the next couple of years. Each promises a different course for stock prices. Fasten your seatbelt or a take a belt of scotch. You may be shocked at how bad it could get.

Scenario one: the Fed engineers a soft landing

This is the outcome the central bank promises. "The Fed is saying, via the surveys of its officials, that it will raise the Fed Funds rate to about 3% in early 2023, and that move will cure inflation," says Brightman. On the afternoon of May 4, the central bank hastened the tightening process by raising its benchmark rate by 50 basis points, double the increase in March, and Fed officials forecast several more half-point increases this year. "The Fed expects its campaign will lower inflation to under 3% in 2023 and 2024, to 2% after that," says Brightman.

In fact, that's just what the bond market is forecasting: The five-year treasury breakeven rate, representing market expectations for average annual inflation over the next half decade, stands at just over 3%. Since prices are already waxing in the high-single digits now, markets clearly expect a drop to the Fed's 2% target range in the out years. "The Fed is trying to manage market expectations, and so far it's been successful," says Brightman. "It's saying good things will happen because we say good things will happen. Janet Yellen and Jerome Powell are selling expectations that inflation comes down, but they're not saying the effort will cause a recession."

If the "immaculate tightening" is en route to success, says Brightman, this is a buying opportunity. "Tech stocks that have high, but not excessively high multiples could do well from here," says Brightman. "Multiples on beaten down stocks could rebound. You wouldn't have an increase in the "equity risk premium," the margin investors demand for returns on stocks versus safe Treasuries you'd get with stagflation, because inflation would come back under control. As a result, interest rates wouldn't be volatile." The markets would still face the probability of higher "real" rates that would hold future gains far below the huge winnings in three years preceding the recent selloff. But rising earnings, and PE expansion by some of today's hard-hit players, could provide modest overall returns if the "optimistic" scenario plays out. Though Brightman still gives this sunny outcome a 20% chance of occurring, he's increasingly skeptical. "I just don't see how you get to 2% inflation by the end of 2023 with raising the Fed Funds rate only at 3%, with inflation now running at over 8%," he cautions.

Scenario two: Fed tames inflation, but at the cost of a recession

In this outcome, the Fed's rate increases indeed spur a recession. But the campaign also succeeds in curbing rampant price increases. "If this happens, unemployment goes from 3% to, say, 5%, and inflation falls back to 2% by 2024," says Brightman. "The downturn lasts a few quarters. Then, the Fed would have room to loosen monetary policy once again." He observes that this isn't a great picture for stocks, since the recession would lower earnings. Still, investors would continue to accept a modest premium for owning equities over treasuries, since they'd no longer face the wildly swinging interest rates that accompany heavy inflation. Then, the big question is what happens to "real" interest rates. If Brightman's right and the confluence of lower savings provided by China and surging demand for scarce capital from an abundance of new investment projects causes inflation-adjusted yields to spike, PE multiples would need to fall. The damage wouldn't be nearly as great as under stagflation since slaying inflation would make markets much safer. But by Fortune's reckoning, the S&P would still sit well below today's levels two years hence as PE multiples shrink, pressured by rising "real rates."

Scenario three: The U.S. ducks a recession, but inflation keeps raging

In this plotline, the Fed shifts course from its avowed goal of returning the inflation trajectory to its current target range. "That change wouldn't be caused by political pressure on the Fed," says Brightman. "It would come from a common mindset at both the Treasury and the central bank that the cost of increased unemployment is greater than the cost of high inflation. But there's no getting around it. Higher inflation means stocks have to fall." Once again, that's because investors would want that extra juice for weathering the risk of the jackrabbit interest rates that are a byproduct of big inflation. That volatility would simply reflect the market's view that the Fed and Treasury were continuing to pursue a badly waffling policy that just traded attacking inflation for adopting still more easy money. Brightman, Arnott, and Cam Harvey a Duke economics professor who doubles as head of research at Research Affiliates, worry that the legacy of gigantic federal spending could force the Fed to retreat. The potential cost of servicing federal debt that's risen to over 120% of GDP, they reckon, could inhibit the central bank from raising rates sufficiently to tame inflation.

"You'd get to a new normal of 4% to 5% inflation," says Brightman. "You get to the end of 2023, and inflation still isn't under control. That just delays the inevitable, and makes the inevitable remedy even worse. The tightening will come, and it will have to be severe. The recession's simply being put off until 2024 or 2025." In this high-inflation-no nearby recession outcome, PE multiples contract as interest rates careen unpredictably. Real earnings growth might continue, since companies have recently been able to pass price increases on to consumers. Still, equities prices would still fall as investors demand lower prices that promise higher future returns, and hence greater safety in volatile environment.

Scenario four: Stagflation returns after half-a-century

The U.S. last suffered stagflation in the 1970s, starting when the Arab oil embargo tripled prices at the pump, and the Fed pursued an ultra-easy money policy that sent inflation into high-single and even double digits. Sound familiar? For Brightman, the central bank created so much new "helicopter" money since the start of the pandemic that inflation is likely to remain in the mid-single digit levels for a couple of years, even if it tightens hard, the path it's now promising to pursue. The combination of big, month-after-month jumps in the CPI, and rising fast-rising interest rates that throttle the economy, would spell stagflation.

What would stagflation mean for stock prices? Hold on tight. Brightman notes that a bout would severely undermine a factor that's helped boost price-to-earnings multiples far above historic norms for the past several years. It's that "equity risk premium," or the extra return investors demand for the unpredictability of choosing risky stocks over the secure returns on government bonds. Along with the "real" long-term rate on Treasuries, it's one of the two components of the discount rate applied to future earnings. Add the ERP to the inflation-adjusted yield on the 10-year Treasury, and you get that discount rate. The lower the ERP, the higher the "present value" of those profits, and the more folks and funds are willing to pay for each dollar in income that a basket of stocks is generating. "The ERP has been low to average for years mainly because we've had modest, stable inflation," notes Brightman. "But high inflation coincides with high volatility of inflation. It varies all over the place from quarter to quarter. There's no such thing as inflation that's both stable and high."

Zig-zagging prices also cause hopscotching interest rates. "High inflation then brings high volatility in interest rates," says Brightman. "With the five-year Treasury yield at around 2.9%, the bond market is expecting a quick return to stable inflation. But that number is already way up, and it's changing as we speak. It's pricing in 'transitory inflation' that's now looking like it's anything but transitory by the day." That trend, he says, is undermining investors' faith in the Fed's and the government's economic policies. "The volatility in interest rates caused by high inflation isn't the problem, it's the reading, like the reading on a thermometer that detects the effect of an illness. It's flashing that the Fed's enacted very bad policies. Investors are seeing less and less probability those policies will be remedied in a way that can prevent stagflation." In addition, companies can't predict the future expense on borrowings to fund new projects, so they retrench instead of reaching for expansion, slowing the economy. In general, the course shifts from a serene sail where investors were happy with a relatively modest cushion for equity returns over the security of Treasuries to a storm-tossed voyage. They'll only board if offered a far larger margin of safety.

That protection can only come from a much higher ERP that drives down stock prices, and gives investors a bigger cushion of earnings for each dollar parked in their portfolios. But Brightman points to a looming change in the second component that, along with a modest ERP, has boosted PEs to heights only seen in the tech bubble of 1998 to 2000: That's the extraordinarily low level of "real," or inflation adjusted, long-term interest rates. "From mid-2020 to the end of 2022, the yield on the 10 year treasury was one point below the projected rate of inflation," says Brightman. "So we had one percent negative 'real rates.' Coupled with the low ERP, that greatly boosted stock prices."

Now, he foresees a big jump in real rates. "They're determined by the supply of savings available for investment, and the demand by companies and the government to make new investments," he says. "The U.S. has benefited from a huge savings glut provided by Asian nations, but primarily from China. Companies, especially asset-light tech champions, were using 'financial engineering' to create moats that led to near-monopoly profits, so demand for investment dollars was weak." Now, the inflows from China are waning as its citizens spend more and save less, and the U.S. needs to undertake a long roster of capital projects. "It's obvious that we've way underinvested in public infrastructure, and that has to change," he says. "In addition, the U.S. will need a dramatic increase in expenditures to address climate change, including spending on renewables, installing charging stations, and expanding the electric grid." The trend towards on-shoring production of everything from semiconductors to rare minerals is well underway, and looking like a lasting trend.

Put simply, Brightman says a return to more normally positive levels of real rates is probably in the cards. "It wouldn't be an upheaval, it would simply be a return to normal," he observes. "Getting to a 2% long-term interest rate is likely, and that's a big shift from negative 1% less than a year ago." That shock alone is bad for stocks. But in stagflation add two more negative forces. First, heavy inflation would increase the ERP or premium investors demand for stock over Treasuries. Piling a fatter ERP on top of a much higher real rate, and the discount rate on future earnings soars. Second, the deep recession would hammer the earnings getting discounted at that much higher number. Falling profits and a rising discount rate are a dangerous cocktail.

How bad could it get? Let's look at what happened starting in January 1973, just before surging oil prices and inflation saddled America with stagflation. At that point, the S&P's multiple sat at over 18. Then, both "real rates" and the ERP exploded, and the economy slid into a steep recession. By December of 1974, the index had shed over 40% of its value, and the P/E had fallen to 10. Of course, the S&P has already lost 12% from its record high at the close of 2021. "So far," says Brightman, "all we've done is erase the gains for the past year. That's not a bear market, and it's not even much of a correction." If stocks follow the same course as in the last period of stagflation, the S&P could dive another 25% or so, reaching around 2300 this time in 2024. As Brightman points out, the destructive power wrought on equities by stagflation is immense. Given the relatively mild fall in stock prices so far, it's clear that investors view anything that grave as a fairly remote possibility. Brightman disagrees, putting the odds at four in ten––putting the markets in far more potential peril than investors recognize.

A key Brightman message is that in three of the four scenarios, stocks fare poorly from here. That means they'd need to fall a lot more from the current levels that are already well off their peak. In the case of stagflation, we're talking––in Fortune's estimation and based on history––an additional fall of 25%. For two other cases, the additional retreat would still likely run in the double-digits.

Of course, he's still giving a one-fifth probability to the smooth landing promoted by the Fed. So he sees an eighty-percent chance that a story line arises that's bad for stocks, maybe really bad. For this writer, Brightman's odds make a lot of sense. Investors should take note, and tighten their seatbelts another notch for the likely storm head.