Despite 2022’s ongoing selloff, US stocks still aren’t priced for the coming economic slowdown.
In fact, one popular strategist says, equities aren’t even priced for today’s macro environment.
“Earnings growth is likely to decelerate, driven by margin compression and slowing top-line growth,” Morgan Stanley’s Mike Wilson said, in the equities section of the bank’s mid-year outlook.
Wilson, who turned cautious last year after being on the right side of the post-COVID bull market, reiterated that the current cycle is “hotter and shorter,” a characterization that’s informed the bank’s macro research during the pandemic recovery.
In his latest, Wilson said he now expects the slowdown “to stay for even longer” than the bank’s equity team envisioned headed into 2022.
There are four key factors in play, he wrote, all of which will be familiar to regular readers.
First, the war threatens to prolong price pressures by keeping food and energy costs high. Global food costs are rising at a near record pace, and Wednesday’s CPI data showed food prices in the US rose a 17th consecutive month, while natural gas prices jumped 3.1% from March and 23% from a year ago. Intermittent drops notwithstanding, energy service prices in the US are rising steadily (figure below).
The US isn’t anywhere near as beholden to foreign supply when it comes to energy, but rising prices are rising prices. And the impact on consumer psychology is real. “These cost pressures continue to weigh on already depressed consumer sentiment,” Wilson remarked.
Second, consumers experiencing high inflation and negative real wage growth will be inclined to press for higher pay. Compensation expense rose at a record rate during the first quarter in the US (figure below) and unit labor costs soared, as productivity plunged.
That’s a headwind for corporate bottom lines. “Labor and input cost pressures remain sticky and continue to pose a risk to corporate profit margins,” Wilson said. 2022’s selloff is a valuation story so far. But if profits decline, it’ll be more than that.
Third, the Fed is hiking rates into the teeth of a burgeoning slowdown, which could exacerbate the pain for consumers by, among other things, putting home ownership even further out of reach.
Wilson wrote that “tighter monetary policy is now having an economic impact, particularly within the housing market, where affordability and mortgage costs are affecting households.” Mortgage rates are rising at a pace unseen in decades (figure below).
Earlier this week, Neel Kashkari acknowledged that the Fed’s efforts to rein in inflation may end up hurting lower- and middle-income families the most, a tragic outcome considering those are the same households that suffer from rising consumer prices.
Fourth, America may have a hidden overcapacity problem. Wilson has discussed this at length over the past several months and he reiterated it this week. The figure (below) helps make the point.
“We’re starting to see signs that excess inventory is building in consumer goods,” he said. “It’s happened more slowly than we initially anticipated, but that means pricing/discounting risk for impacted companies can linger for several quarters.”
When taken together, those four factors suggest stocks have room to fall further or, at the least, that markets will remain volatile and unruly.
“We continue to believe that the US equity market is not priced for this slowdown in growth from current levels,” Wilson wrote, adding that “based on our fair value framework, the S&P 500 is still mispriced for the current growth environment.”
The bank’s model indicates an S&P price of between 3,700 and 3,800 on a tactical (i.e., near-term) basis.
Morgan’s 12-month price target is 3,900 (figure above). So, Wilson effectively suggested stocks could easily overshoot to the downside given the headwinds detailed above.
I’ll leave you with a short excerpt that finds Wilson summarizing the bank’s bear case for US equities. To wit:
In our 3,350 bear case, the market puts a 15.9x P/E multiple on forward (June 2024) EPS of $212. This scenario assumes a recession. We have earnings growth decelerating in 2022 and then outright negative in 2023(-10%) from a calendar year standpoint. We then see 2024 EPS growth rebounding off of recession comps, finishing the year +17%. In this scenario, margin contraction is more severe in 2022 and 2023, and nominal top line growth nearly contracts on a year-over-year basis by 2023, only kept modestly positive by inflation. Bottom line: sticky input/labor cost inflation drives sustained margin pressure. Payback in demand is a dominant theme, leading to a broad deceleration in sales growth. That combination takes EPS growth negative in 2023. At the same time, stickier inflation keeps the Fed on a hawkish path despite decelerating growth and tightening financial conditions.
Thanks a lot for your always informative perspective. My own thinking has been keen on the very likely impact of the war influencing ongoing inflation. On the other hand, my fingers are crossed that Russia’s ineptitude in making war will shorten the conflict. The poor morale of Russian soldiers and the long-range howitzers that NATO and the US are sharing with Ukraine may help to facilitate a quicker ending. But that process requires time and luck.
Post suggests higher real interest rates. We live in a leveraged economy, higher reals will cause the economy to contract and will lead to lower interest rates. Could we be experiencing another taper tantrum?
I had no perspective about the question of over-capacity. For so many months and years it has been a situation of “if you sell it, they will buy.” I feel it’s peculiar to the landscape in which we’ve been living, where money-printing by the Fed has contributed to a free-wheeling philosophy about spending, most especially by the government. The deceleration Wilson suggests would seem to be a natural outcome. I’ve always found that Morgan does a good job of informing my inflation expectations. The 2023 earnings projections are sobering. I hope it’s just -10%.
So Morgan’s 12 mo target is 3900. Wells just told me they see 4500-4700 in a year and 4900+ in 2023. Somebody’s got something wrong here.
My feeling is that 1Q was the bulk of (not all of) the valuation implosion and in 2Q negative revisions will take the limelight. By 3Q those with lots of cash may be able to scoop up bargains.
A good part of the inflation problem is due to external forces – Russia/oil and China/supply chain. Some more is due to the effect of Covid and a roaring bull market on consumer behavior. These factors are temporary, even if not short-lived enough to be “transitory”. It is possible that in 3Q the inflation tide will be cresting and ebbing, enough for investors to see a glimmer of a Fed put at the end of the Fed tightening tunnel.
Bottom line, my base case is that buying conditions will return somewhere around 3Q, with maybe some front-running attempts. So chill out, take the summer off, live to fight in the late-summer / fall?
So his “bear” case is only a drop in earning of 10%. That’s not very bearish. Between 2014 and 2015, S&P 500 earnings dropped ~15% and I don’t think that era was referred to as a “bear” market. Prior recessions had the following drop in S&P 500 earnings: almost a 90% drop (2008/2009), almost a 50% drop (2001), almost a 25% drop (1991)… it’s interesting to see that over the past 30 years, each subsequent recession has experienced a significantly larger drop in S&P500 earnings.
Isn’t the S&P heavily weighted to the Tech Oligopoly? It’s hard to see why revenues truly decline 25% for these giant cash vacuum cleaners of Microsoft (Enterprise), Apple (Consumer), Google (Ads), Amazon (ECommerce), etc. The global (market) penetration of tech isn’t complete, and generationally they’re still winning over Boomers (and GenZ purchasing power is going for digital stuff)…
So it’s a technicality but I feel like the S&P won’t fall as far as those historical drops you listed.
Just as one example: look at the consensus FCF growth for AMZN over the next five years. It is eye-watering, astounding, maybe even risible. Now re-do the valuation assuming FCF growth is merely fantastic. The result is not pleasant.
I run a SP500 valuation model. Bottoms up, for each name pull in consensus FCF ‘22-‘26 and other data, assume a terminal growth (my default is 2%), compute WACC and then a DCF valuation.
Also, pull in consensus revenues, EPS, EBITDA, book, pull in multiples for selected past period, compute multiple-based valuations.
If desired, apply some general adjustments like X bp higher or lower rF, Y ppt higher or lower FCF CAGR, different terminal growth, Z points higher or lower multiple, etc. If desired, apply adjustments to specific names. Roll up result by sector and to the index.
I mostly use this to see which sectors or names look undervalued or overvalued relative to the rest, under given scenarios.
Sometimes I’ll play with the inputs to see how overall index valuation looks, or what scenarios are discounted at current valuations.
As you might imagine, the DCF valuation is most sensitive to terminal growth, rF, and FCF ‘22-‘26 CAGR, in descending order. The multiples valuation is most sensitive to what past period you pull the historical multiples from.
These sorts of models are mostly useful for relative and sensitivity analysis. Who really knows if terminal growth “will be” 2% or 5% – not I! – but it is useful to see how a certain degree of incremental optimism or pessimism can potentially affect prices.
Broadly speaking, rF +200 bp higher than current could be pretty impactful to SP500 valuation, all else equal. We’re talking a thousand points lower. Cutting CAGR by low-single-digit ppts, to the extent that also lowers expectations for terminal growth, could be similarly impactful.
The point, if there even is one, is that if macro and/or fundamentals move negatively, in a significant way, there isn’t “valuation support” here.
I guess that’s Captain Obvious stuff. Just looking at where SP500 is today versus where it was just three years ago would show that too, without all the modeling.
Sorry, it has been a while since I last ran the model (a whole week!). Replace “a thousand points” by “five hundred points”.
Thanks jyl!