Mike Wilson The (Tactical) Bull

Morgan Stanley’s Mike Wilson is bullish. Tactically, but any sort of bullishness from Wilson is news.

Thanks in no small part to a prescient July 2018 note in which he suggested a “proper rain storm” might be coming for US tech shares, the media affords far more coverage to Wilson’s bearish prognostications than his more constructive calls. But his reputation as a perpetual rally skeptic isn’t wholly without merit. Although he’s been on the right side of key bullish calls, he’s the furthest thing from shy when it comes to turning bearish. That makes him something of an outlier among habitually bullish sell-siders. Hence the media’s penchant for identifying him with bears.

Currently, though, he suspects that value on offer at the long-end of the US curve could pressure yields lower, “provid[ing] the necessary fuel for the next leg of the tactical rally in stocks.” Wilson appears to be pushing his profit reckoning call down the road. “Full capitulation” on forward earnings estimates “may take a few more months,” he said, in a Monday note that spoke highly of his market acumen.

As discussed here at some length last week in “Schrödinger’s Economy,” Q3 reporting season may end up looking a lot like Q2 in the US, where that means lowered bars make for easy “beats,” and consumers’ willingness to pay up for goods and services helps preserve margins as households effectively absorb higher input costs so corporates don’t have to. When you think about dour macro commentary from management, ongoing reports of hiring freezes and bombastic rhetoric from billionaires, don’t forget that all of that was present during Q2 reporting season too.

Wilson was (very) clear that Morgan’s call isn’t a fundamentals-based, long-term thesis. “To be clear, this is a tactical call based almost purely on technicals rather than fundamentals which remain unsupportive of higher equity prices over the next three to six months,” he wrote, before summarizing recent market dynamics. “The price action [has] become more technical than normal over the past few months as investors are forced to do things they don’t want to, both on the upside and the downside,” Wilson said, adding that,

Such is where we are in this particular bear market which began well over a year ago for the average stock. More specifically, many active managers are having a difficult year which puts them on their back foot and unable to fight powerful trends both up and down. This suggests passive trend following strategies can have even more influence on price than normal. Witness September which resulted in the worst month for US equities since the COVID lockdowns in March 2020. Passive flows simply ran over anyone trying to make a stand on the long side. The same price action can happen on the upside, and one needs to respect that in the near term, in our view.

Needless to say, there’s a lot going on from a mechanical, systematic, options-driven flow perspective. Wilson barely scratched the surface on that front, but he’s a fundamental, top-down guy, not a derivatives strategist — given his remit, Wilson’s summary more than sufficed.

He came across as somewhat vexed while conceding that this quarter, like Q2, may again find corporate America managing to clear a low bar, thereby giving bottom-up consensus (i.e., company analysts) plausible deniability when it comes to persisting in relatively rosy estimates for 2023.

“This seems ridiculous in the face of what’s going on with costs, demand destruction from higher inflation and the yet-to-be-felt effects from the most aggressive Fed tightening campaign in the past 40 years,” he said, of still minuscule cuts to NTM EPS forecasts. “Yet here we are waiting for the engraved invitations to arrive,” he continued. In case you haven’t noticed, Wilson is an engaging writer as far as sell-side strategists go.

Extending the mailed invite analogy, Wilson said that “markets can remain stubbornly over-valued and near sighted until those invites are opened and read out loud.”

As the figure (above) makes clear, there’s been very little in the way of capitulation on the forecast front, but unlike prior downturns, stocks have pre-traded assumed cuts. Or maybe they haven’t. What’s happened to stocks in 2022 is a rates story. Specifically, a higher rates story, which led to an acute bout of multiple compression and a bear market.

That latter bit is key for at least two reasons.

1. The valuation-driven bear market means equities are trading low enough to be consistent with “a lot of bad news,” as Wilson put it, and for now it doesn’t much matter if that bad news is higher rates combined with geopolitical and macro uncertainty instead of a likely drop in profit forecasts. Until that drop actually materializes, stocks may have a hard time moving much lower.
2. The already historic rise in yields has left bonds the cheapest in recent memory. That opens the door to a long-end rally, particularly if inflation recedes and the Fed is unable, unwilling or both, to live up to its own aggressive rates guidance, let alone market pricing for the terminal rate which, prior to a Nick Timiraos intervention last week, looked poised to run beyond 5%. I suggested the Fed was likely uncomfortable with that, at least for now.

Wilson called the S&P’s rebound off the 200-week moving average “one of the most impressive stands we have ever seen” and said the timing, around CPI, was “very important.”

Tying that together with the two points enumerated above, Wilson wrote that CPI is “even more important for the rates market than equities, and rates have been the single biggest driver of stocks lower this year.” As those who follow Wilson’s weeklies are aware, the ERP is a fixture, as it should be. On Monday, he said stocks are “essentially calling BS on the Fed guidance and the rates markets’ interpretation of it by taking the ERP to 20-year lows in anticipation of falling rates over the next year.”

Stocks may well be correct in that regard, according to Morgan Stanley. The bond market, Wilson suggested, is currently “as irrational about inflation next year as equity markets are about earnings” and “for the same reason.” Bonds, he said, are beholden to the Fed’s guidance on rates and stocks to corporate guidance on profits. If you ask Wilson, both are wrong, it’s just a matter of how long it takes for each asset to recognize its mistake and reprice accordingly.

He mentioned the Timiraos article. Everyone did on Monday. The reaction in rates, and accompanying reversal in stocks late last week, was a reminder that “we don’t need the Fed to cut or even pause… given how offside the market may be at the moment as Friday’s price action suggests.” (Recall that the Timiraos piece didn’t suggest a pause. He merely said some Fed officials may be debating whether to signal to markets that the 75bps cadence could see a step down to 50bps in December.)

Wilson’s Monday note was, in my judgment anyway, one of his better pieces. He plainly has a very good and highly nuanced grasp of sundry push and pull dynamics, the ebb and flow of Fed speculation and how it all influences rates and equities and on session-to-session basis. That’s not easy, even for a veteran like Wilson.

Out of respect for the depth of the original analysis, I’ll eschew the temptation to editorialize and paraphrase any further, in favor of leaving you with one final short excerpt from his 43-page Monday missive. To wit, from Wilson:

The bottom line [is that] falling inflation expectations could lead to a period of falling rates that may be interpreted by the equity market as bullish until the reality of what that means for earnings is fully revealed. Given the strong technical support just below current levels, stocks can continue to rally toward 4000-4150 in the absence of capitulation from companies on 2023 earnings. However, should rates remain sticky at current levels, all bets are off on how far this equity rally can go beyond current prices. Last week’s price action in stocks and bonds is supportive of this tactical view playing out to the upside. First, it’s remarkable to us that stocks were able to rally last week at all in the face of 10-year yields making 15-year highs. Right or wrong, the equity market is looking forward to rates falling with inflation next year. Second, Friday’s price action is indicative of just how offside both stock and bond markets might be to a change in Fed policy that could be forthcoming at the Fed’s next meeting on Nov 1-2. As a result, we stay tactically bullish as we enter the meat of what is likely to be a sloppy earnings season. We just do not have confidence that there will be enough capitulation on 2023 earnings to take NTM EPS down in the manner that takes stocks to new lows right now. Instead, our base case is that happens in either December when holiday demand fails to materialize or during Q4 earnings season in January/February when companies are forced to discuss their outlooks for 2023.