Stocks are oversold and Treasury yields may have stabilized after running sharply higher, setting the stage for what could be a “material” bear market rally.
That’s the good news from Morgan Stanley’s Mike Wilson who, on Monday, released an extended version of his mid-year outlook. The bad news is, the lows may not be in.
Late last year, Wilson suggested the S&P would de-rate consistent with Fed hikes, as policymakers moved belatedly against generationally high inflation. At the time, the benchmark still traded on a nosebleed multiple. The median P/E, Wilson reminded investors on Monday, was actually higher in November than it was in the late 90s.
So far, 2022’s selloff is a de-rating story. Surging real rates and tighter financial conditions bled the most expensive stocks and, ultimately, the S&P de-rated to around 17.5x (figure below).
“It’s fair to say we have achieved our de-rating targets [but] all of the multiple contraction to date has resulted from the Fed’s very aggressive path on tightening and the subsequent rise in 10-year yields,” Wilson said Monday, noting that the ERP is mostly unchanged since November.
Wilson suggested rates might have actually overshot “by incorporating more hikes than the Fed may be able to deliver in this cycle based on the significant damage to financial asset prices and the approaching slowdown that looks much worse than it did just a few months ago.” He mentioned the drag from the war and China’s lockdowns.
Chinese retail sales tumbled more than 11% last month and industrial output shrank, data out Monday showed. The figures raised the odds of a Q2 contraction in the world’s second largest economy and analysts are now trimming forecasts for US growth too. Wilson also cited a “significant” increase in the cost of capital in the US, with the most glaring manifestation being mortgage rates, which are up 65% in a matter of months.
He called the recent decline of the ERP to post-GFC lows “nearly inexplicable,” but said the turmoil associated with the war may have increased the appeal of the S&P 500 as “the most defensive and liquid equity market in the world.”
Now, though, the US economy looks poised to slow, and Wilson sees evidence of waning momentum in earnings. “The ratio of negative to positive earnings continued to rise [and] the quality of earnings deteriorated as incremental operating margins rolled over for many companies and sectors,” he said, of Q1 results. He pointed to big-cap US tech, which matters immensely due to index weighting.
Although there’s some evidence that analysts are becoming more cautious, full-year estimates for 2022 were mostly unchanged at the end of earnings season, which could be problematic. “This effectively raises the bar for the second half of the year,” Wilson remarked, noting that H2 is “about the time the economy will be feeling the effects of higher rates and other headwinds.” Remember: Monetary policy acts on a lag.
To be sure, the market is now coming around to the distinct possibility that the US could experience a recession at some point over the next 12 to 24 months. That realization might have been a turning point but, as alluded to above, there’s a problem.
“The market’s focus has shifted to growth and quite frankly, it’s what we’ve been waiting for to call an end to this bear market,” Wilson said. “Unfortunately, while we think the equity market has adjusted for higher interest rates, we’re just not there yet with regards to the ERP.” The simple figure (below) illustrates the point.
Going forward, one question is this: Will purportedly forward-looking stocks pull forward weaker earnings growth? Or, the corollary: Will equities have to “see it to believe it” (so to speak), in the form of pervasive guidedowns?
In the very near-term, stocks could rebound. Traders and investors came into the back half of May in decidedly poor spirits. As I put it over the weekend, that may be the most compelling argument for a near-term, bear market rally. Sentiment extremes are decent contrarian indicators and market participants are extremely disheartened.
Wilson echoed that, but said that following any bear market rally, Morgan Stanley’s US equities team “remain[s] confident that lower prices are still ahead. For the S&P, that could mean 3,400, where Wilson said the benchmark would find “both valuation and technical support.”
My gut feeling, not based on any real analysis but just on my imperfect memory of the last couple of cycles, is that markets don’t usually bottom until there is a lot of actual company fundamental badness on the tape, then they bottom before the badness is done.
Oh heck, let’s take five minutes and look at some charts.
2008: SP500 NTM est EPS peaked 6/2008, stayed fairly flattish until 9/2008, then started a steep decline from 10/2008, bottomed 4/2009, followed by recovery. SP500 EBIT margin stayed robust until 2/2009 and bottomed 11/2009. SP500 price peaked 10/2007, started a decline that really accelerated in 9/2008, bottomed 3/2009, then began the recovery.
2000: SP500 NTM est EPS peaked 10/2000, then started a steep decline, bottomed 12/2001, followed by a fitful recovery that didn’t really take off until 2/2003. SP500 EBIT margin stayed robust until 5/2001 and bottomed 11/2002. SP500 price peaked 3/2000, chopped around until 9/2000, declined until 10/2002 (almost -50%), then began the recovery.
So in both of the last two bear markets, the SP500 decline started well before NTM est EPS started to decline, and didn’t end until NTM est EPS had started definitively breaking down. The lag from NTM est EPS breakdown start to price bottom was quite variable, 5 mo or 2 yrs. SP500 EBIT also started breaking down before the market bottom, but much later than NTM est EPS.
Someone with more time can look at sales, and other metrics, but anyway I think we need to see a lot of major names “miss and lower” materially before sounding the all-clear.
Stock reactions to material miss and lower reports have been large and negative. For names that haven’t already been hammered, I would think the same reaction is likely. Investors can take the top 30 largest market caps in the SP500, look at where they might trade to after a couple of miss + lower reports, and infer a target level for the index, using a bottoms-up analysis. I suspect Wilson’s team has done that, even if strategists usually don’t publish their downside scenarios for individual names for various reasons.