Mike Wilson Never Liked This Rally Anyway…

“The equity market became a victim of its own momentum over the past few months as CTAs and other price insensitive buyers drove valuations to unrealistic levels,” Morgan Stanley’s Mike Wilson wrote Monday.

He’s mostly right. The summer rally in US stocks was most assuredly a mechanical bull, turbocharged by under-positioning and squeeze dynamics. The flows-based rally certainly wasn’t the product of rational actors collectively deciding stocks were fundamentally undervalued. But I’m not sure “price insensitive” is the best term. We tend to conceptualize of systematic flows as universally “price insensitive,” but that’s not strictly accurate in all cases. Rules-based trading involves price signals, after all.

Whatever the case, the rally ran out of steam two weeks ago and risk sentiment was impaired to start the new week, as markets digested Jerome Powell’s “restrictive for longer” message in Jackson Hole. Although multiples have contracted anew, they’re still “well above” fair value, according to Morgan’s Wilson, who said stocks “may have gotten too excited and even pre-traded a Fed pivot that isn’t coming.” The summer rally, he remarked, “is likely over for now.”

He called the move “pretty textbook.” The rebound from the summer lows followed an outright collapse in market breadth (to the lowest levels in recent history) and stalled at the 200-day moving average (figure above). That’s “quite ominous to even the most basic technical analysts, like us,” Wilson quipped.

As for the fundamentals, he spelled out the problem in straightforward terms. “The ERP never went above average,” Wilson wrote. “Instead, the fall in the P/E from December to June was entirely a function of the Fed’s tightening of financial conditions and the higher cost of capital.” The figure (below) illustrates the point.

On Wilson’s model, which leans heavily on YoY changes in PMIs, the S&P’s ERP should be some 120bps higher. The implication, incorporating 3% on US 10s, is a P/E of 14, lower than the June nadir.

But the real issue is earnings. While market participants obsess over the Fed, it’s forward estimates that continue to pose the biggest risk to equities. Wilson said Monday that corporates preempted Q2 results by managing expectations lower, leading to the perception that earnings were better than expected. He then employed a bit of understated derision, his signature, to cast doubt on the viability of an investment thesis based on that perception.

“Call us old school, but better than feared is not a good reason to invest in something if the price is high and the results are soft,” Wilson wrote. “In other words, it’s a fine reason for stocks to see some relief from an oversold condition but we wouldn’t commit any real capital to such a strategy.”

He then returned to the margins discussion. For Morgan Stanley, forward earnings forecasts are still “significantly too high.” Revisions breadth has deteriorated meaningfully (figure on the left, below), but the crucial point is that we don’t yet know how deep the cuts will ultimately be assuming, as Wilson does, that they materialize. So far, they’ve been “de minimis,” which is typical. Bottom-up consensus has fallen just ~1% for the S&P 500 and is still some 18% above trend (figure on the right, below).

Although management, and, as a consequence, company analysts, lowered the bar for Q2 results, the out year forecasts barely budged. Excluding energy, NTM EPS estimates have fallen 5%, but Wilson suggested that’s “just the beginning.” In a worst-case, Morgan Stanley worries forward numbers could fall as much as 20%.

The irony from Powell’s Jackson Hole speech is that rates were relatively subdued, notwithstanding Monday’s loud headlines touting 15-year highs in two-year Treasury yields. Maybe “nonplussed” is the better adjective, but whatever your preferred description, stocks were more shocked by Powell than bonds. As Wilson wrote, that meant the vast majority of the decline in multiples was attributable to a higher ERP, which, as noted above, remains nowhere near fair value on Morgan’s models.

“Importantly, we think Friday’s action could be the beginning of what is likely to be an elongated adjustment period to growth expectations,” Wilson said. “In our experience, such adjustments to earnings always take longer than they should.”