Stocks are innocent until proven guilty. Not in the court of Morgan Stanley’s Mike Wilson, but in the court of public opinion, which Wilson on Monday acknowledged is all that ultimately matters in the very near-term.
“Until proven otherwise, stocks may hold up,” he wrote, in the course of reiterating his steadfast contention that investors are, however unwittingly, staring down “a significant cyclical downturn for earnings forecasts.”
Wilson needn’t defend this view as vociferously as he’s taken to doing. It’s not particularly controversial, and I don’t think market participants, by and large, harbor the sort of doubt Wilson seems to attribute to investors. Most are fully aware of the potential for earnings growth to decelerate meaningfully, and perhaps turn negative as a confluence of well-documented margin headwinds and execution missteps finally overcome the pricing power story.
The problem isn’t Wilson’s thesis, and it certainly isn’t Wilson’s recent track record, which is good as top-down sell-side strategists go. In July of 2018, he famously called the mini-bear market that defined the latter half of that year, for example. He was bullish coming out of the pandemic selloff, which was obviously the correct call. And although he was a few months early, he predicted the current bear market. Crucially, Wilson correctly identified the catalysts and the sequencing for equities’ ongoing swoon.
There was one exception, which he discussed at some length in his latest. If you follow Wilson’s analysis, you know that just about the only thing he’s been off on is the ERP. On Monday, he called that “the single biggest miss for us this year.” Although he got the rates part right while predicting valuation compression, the ERP is arguably lower than it should be. After last week’s rebound for US shares, stocks are “even richer on this basis than… at the highs in August,” Wilson remarked.
But it’s not just that the ERP is well below average that vexes Wilson. What he sees as particularly disconcerting is the juxtaposition between a low ERP and the spread between Morgan Stanley’s forward NTM EPS model and consensus forward estimates (illustrated in the figure below).
The chart header is particularly helpful in this instance given that the visual is a bit cumbersome.
As usual, Wilson delivered a compelling rationale couched in straightforward terms once he worked his way through the particulars.
Some argue a lower index ERP is justified in light of inflation realities. “The argument is that stocks are a better asset to own than bonds in such a regime and therefore deserve a lower risk premium,” Wilson said.
Although he’s on board “with the premise,” and was keen to remind investors that he “in fact used that exact statement to go all-in on stocks in late March 2020,” Morgan Stanley’s US equities team worries it may be less of an “appropriate rationale” going forward, especially if earnings forecasts roll over.
“It’s typically margin compression that’s the early/more material driver of EPS downside in periods of negative earnings growth, not nominal top line, which could be aided by higher inflation,” Wilson wrote, summing up. “Nevertheless, until proven otherwise, stocks may hold up until it’s no longer deniable we are entering a steep earnings contraction.”
In other words: Stocks may hold up until it’s too late.
Wilson described himself as “highly convicted” that the bank’s below-consensus earnings outlook for the S&P will be borne out. It’s even possible, he suggested, that the bank’s bearish view is “optimistic.”