‘Make No Mistake,’ It Can Get Worse For Stocks

It’s been an especially rough year for US equities.

In fact, 2022 was worse than 2008 through the beginning of September on at least one measure. Less than a quarter of all stocks in the Russell 3000 came into this month in positive territory for the year, Morgan Stanley’s Mike Wilson said. By comparison, almost half were higher headed into September of 2008, when the world stopped spinning.

You might be inclined to suggest things can’t get a lot worse, but that’d be a mistake, according to Wilson. In itself, a “historically bad” year for stocks is no reason to be bullish, he said.

“While the June low for stocks and bonds was dramatic, we’ve consistently been in the camp that it wasn’t THE low for the S&P 500 in this bear market,” he wrote, adopting a cautious cadence at the beginning of what, historically, is the worst month for stocks.

In contrast to the rates-driven selloff that found equities de-rating sharply during the first half of the year, Morgan Stanley thinks the next leg lower will “come mostly via a higher ERP and lower earnings.”

This is familiar territory for Wilson, but he plainly thinks it deserves as much attention as it can get. The bank’s leading earnings models “are all flashing red for the S&P 500,” he reiterated (figure below).

Morgan Stanley has “high confidence” in the contention that minuscule cuts to forward estimates are just the tip of the proverbial iceberg.

Although he sounded somewhat indifferent to the very near-term outlook, Wilson was unequivocal about Q4. “Make no mistake, as the weather turns chilly this fall, so will growth, which will weigh mightily on stocks given the paltry ERP investors are getting paid to take this risk,” he warned.

Meanwhile, Deutsche Bank’s Parag Thatte and Binky Chadha suggested equity positioning is already consistent with recession — or at least among the discretionary crowd. The bank’s measure plunged last week into just the 8%ile, due mostly to a big drop in discretionary investor positioning, which now sits at the lowest since July 2020 (figure below).

“Discretionary positioning tends to be closely tied to indicators of macro growth, such as the ISM,” Thatte and Chadha wrote, adding that “at current levels, discretionary positioning is commensurate with a steep drop in the ISM to 47.”

The juxtaposition with August’s ISM prints is notable. Both were much better than expected, as manufacturing and services handily topped consensus. The disparity between discretionary positioning and growth, proxied here by ISM, is larger than at the June market low, Deutsche remarked.

“Long/Short and macro hedge funds continue to have de minimis exposure to US equities,” Nomura’s Charlie McElligott said late last week, noting that on a one-month rolling basis looking back nearly two decades, the Long/Short crowd’s beta to the S&P sat in just the 1.4%ile at the end of August.