I doubt there’s much in the way of reader appetite when it comes to laborious recaps of sell-side calls and how they evolved over the course of the pandemic.
One particularly vexing issue involved the tension between predicting gains for financial assets and a macro backdrop defined by widespread economic devastation. While economies recovered, some of them rapidly, many businesses are gone forever, lost over the epidemic’s event horizon. And that’s to say nothing of the physical suffering, which is ongoing and getting worse depending on the locale.
There’s something seemingly uncouth about making rosy projections (of any kind) considering how many lives were lost and livelihoods destroyed over the past year. But if every prediction about the likely trajectory of financial assets is compelled by decorum to mirror the scope of the tragedy, then every prediction will be a semblance of dour.
In essence, the key to trading the pandemic was predicting that the gravity of the situation would compel an unprecedented policy response, involving not just a monetary backstop for markets, but a fiscal push designed to simulate (that’s simulate, with one “t,” not stimulate with two) economic activity in part by replacing entire income streams for whole populations. If you bet on that, and were convinced that an engineered recession would be shorter than a “natural” downturn, you had a solid case for a “V-shaped” rebound. Toss in multiple effective vaccines, and the case was even stronger.
Through it all, Morgan Stanley was remarkably persistent in touting the “V-shaped” narrative, not just for equities and not just for the economy, but in general, across their research. The message was consistent, and it remains so, although their bearish bonds call is currently grappling with an annoyingly persistent rates rally, which continued on Monday.
In his latest, the bank’s Mike Wilson reiterated the “mid-cycle transition” thesis — the economy and markets are moving from peak growth and “maximum monetary accommodation” to… well, to some other conjuncture. Comparable years include 1994, 2004 and 2011, Wilson said Monday. “In all cases, US equity markets were characterized by… falling P/Es, narrowing leadership, a skew towards quality and a 10-20% correction in the major indices.”
As noted last week, some of those boxes have been checked in 2021. Breadth is deteriorating, there has, in fact, been some de-rating in select corners of the market and drawdowns were witnessed first in various manifestations of “froth” and then in popular reflation trades which recently erased YTD relative performance alongside the bond rally and attendant curve flattening.
What’s missing, though, is an index-level drawdown. One reason for that is resiliency among the tech heavyweights, which have benefited from the bond rally, bull flattening and concurrent worries about the growth outlook. The figure (on the left, below, from Morgan) is self-explanatory, and even if it wasn’t, Wilson put some handy, red annotations on it.
And then there’s the Fed. “We think the primary missing ingredient for [a] correction [in the major averages] is the Fed’s slower than normal withdrawal of monetary accommodation given how much progress has already been made,” Wilson went on to remark, adding that “this delay in removing accommodation has kept long-term interest rates much lower than the economic fundamentals would suggest.”
There’s good news and bad news. The good news is, the average stock has already de-rated below 19X. The bad news is, the S&P still trades up above 21X, which means the index “has about 15% to go to reach our year-end target,” Wilson said, before summing it up in one refreshingly colloquial sentence, amenable to a lazy summer Monday: “In short, our mid-cycle transition has played out at the sector level and we see no reason why it won’t finish with the typical index level reset on PEs and price.”
That’s the 30,000-foot view. In addition, Wilson took something of a deep-dive into earnings revision breadth and what fluctuations have historically entailed for US equity performance. Higher corporate tax rates would be a big shock, as analysts would need to immediately incorporate (no pun intended) the implications for bottom lines. Obviously, that would force revisions lower.
Even if revisions breadth stays elevated at two standard deviations above the long-term average, the implied three-month return for the S&P is just 1.2% (figure on the right, from Morgan, above). “A move back down to average levels of revisions breadth implies returns of -14%,” Wilson noted, calling that “a poor risk-reward skew.”
The bank’s mid-year 2022 S&P price target is 4,225, around 4% lower than Monday’s levels.
