Bear Market Rally On Borrowed Time, S&P To 3400: Wilson

US equities may loiter around current levels for a while, but another swoon is coming, likely following Q2 earnings season.

That’s the message from Morgan Stanley’s Mike Wilson, who on Monday noted that revisions breadth has finally turned negative. “It’s been a slow bleed,” he remarked.

The overarching question is whether the near 20% drawdown on the S&P (figure below) was enough to account for the risk to earnings from margin headwinds and a decelerating economy. If the answer is “yes,” you could argue stocks have now priced in the inflation shock, the rates shock and the recession shock, leaving equities free to look even further into the future to price better growth outcomes down the road.

Spoiler alert: Wilson doubts that thesis. “In the absence of further revisions in the near-term, that view can hold up [but] if earnings revisions don’t reaccelerate, we think the price remains wrong,” he said. “This is why we still think it will be difficult for the equity market to make much upward progress this summer/fall from current levels.”

He mentioned last week’s Microsoft guidedown, which I generally ignored, not because the currency headwind (which the company cited while cutting its profit forecast) doesn’t potentially bode ill for other companies, especially multinational software companies, but rather because dollar strength could dissipate, software stocks have already underperformed and after a fleeting bout of indigestion, the market pretended it didn’t happen.

Wilson thinks it’s not necessarily a good idea to ignore such things or to sweep them under the rug, especially not at a time when profitability is already being squeezed on multiple fronts. He also mentioned Morgan Stanley’s expectations that Apple’s services business may disappoint.

“Equity markets, however, ignored these revisions for the most part with both stocks holding in [but] we think investors hoping for a quick reversal of earnings revisions breadth may be disappointed,” Wilson said. “Either the price needs to come down to reflect the earnings risk or the estimates need to fall.” He thinks both of those risks will materialize.

The figure (above) helps illustrate the potential impact of the currency drag.

Of course, corporates aren’t exactly keen on delivering bad news to shareholders, and the street is even less keen on cutting forecasts, so it could be a while before all of this manifests in across-the-board revisions. That’s one reason Wilson is “open minded” when it comes to the notion that stocks might prove a semblance of resilient in the very near-term.

But once earnings season rolls around, stocks could roll over with revisions. “In the absence of a recession or a shock like the COVID lockdowns, negative earnings revisions typically take longer than they should, and this time is likely to be no different,” Wilson wrote, adding that “the bear market rally that began a few weeks ago can continue for a few more weeks until the Fed makes it crystal clear they remain hawkish, and earnings revisions fall well into negative territory.”

At that point, the one-two punch of Fed resolve and a less sanguine profit outlook for corporate America “should ultimately take the S&P 500 toward 3400 by mid/late August,” according to Morgan Stanley.