The S&P 500 could sink 23% in a recession, so investors should consider some downside protection, Goldman Sachs says

• The baseline view for Goldman Sachs is that the S&P 500 will rise 7% over the next 12 months.
• But the bank's economists also see a 25% chance of a recession in that span.

While there's likely more upside in the S&P 500, investors should consider some downside protection in the face of recessionary risk, Goldman Sachs said.

The bank's baseline view is that the S&P 500 will rise 7% over the next 12 months to 4,700, but Goldman's economists also estimate a one-in-four probability of a recession playing out in that span.

If a recession occurs, it would bring the index down to 3400, and it's a situation investors should be ready for, according to Goldman.

"We prefer to maintain upside exposure to equity while utilizing the options market to hedge the potential 23% downside in a recession scenario," the note said.

The warning comes as the S&P 500 is currently in the midst of a bull market run, led by a rally around mega-cap tech stocks.

Over the past months, their valuations have been pumped up by Wall Street's excitement around artificial intelligence, as these companies look to implement the new technology into their services.

The note encouraged investors to hedge, listing several reasons. For one, the mega-cap rally narrowed market breadth, adding downside pressure. According to Goldman, breadth drawdowns are historically followed by significant slides in the S&P 500.

Meanwhile, further upside may be limited by a crowding of bullishly positioned options, the analysts wrote. While investors were well hedged between March and May, Goldman found that many began to pay more for single stock calls in late May.

Alongside this, stock markets have already priced in an optimistic growth outlook, as increasing confidence has meant that investors added equity exposure throughout 2023.

The noted added that equity valuations are high — both in absolute and relative terms — and trading at 19 times their price-to-earnings ratio. Historically, when the S&P 500 trades this high, it is usually followed by a 14% drawdown over the next year, the analysts wrote.