Wall Street’s favorite bear has good news and bad news.
Ok, it’s mostly bad news. Or, if that’s too strong, it’s fair to say that if Morgan Stanley’s Mike Wilson is correct about what’s ahead for US corporate profits, 2023 could be a very frustrating experience for market participants, albeit hopefully not as frustrating as 2022.
I’ll eschew the temptation to bury the lede for once. In Wilson’s bear case, the S&P drops to 3,000 “sometime” in the first half of the new year, before recovering to 3,500 by year-end (figure below).
Obviously, that’d be painful. It implies nearly 25% downside over the next six months from Friday’s close, and suggests investors can “look forward” to another very poor calendar year.
Note that even in Wilson’s bull case, stocks have virtually no upside from current levels.
So, what drives the bear case? It’s not just Mike’s (sometimes overstated) penchant for casting a wary eye at peers’ starry-eyed forecasts. Rather, Morgan Stanley’s leading earnings indicator is now dramatically below bottom-up consensus.
If you follow Wilson’s work, you know he’s been skeptical of profit forecasts for quite some time, and while the earnings reckoning many top-down strategists suggested might begin in Q2 was pushed out, Q3 reporting season was spotty, at best. Going forward, spotty might be the best we can hope for.
There are only two examples of bottom-up consensus (so, company analysts) being as far detached from Morgan Stanley’s non-PMI leading EPS indicator as it is today. Those two examples: 2001 and 2008 when “the outcome wasn’t pretty,” as Wilson dryly put it. The figure (below) illustrates the disconnect. If past is precedent, a recession is nigh.
“We think many companies are likely to experience severe negative operating leverage as growth slows materially toward our economists’ very low growth forecast for next year,” Wilson remarked. Morgan Stanley sees real GDP growth of just 0.5%.
In the event of a recession, the outlook for operating leverage would be considerably worse, or at least initially. That, in essence, explains Wilson’s $180 bear case for S&P 500 aggregate index EPS next year. That’d equate to a 16% profit contraction versus his below-consensus 2022 EPS forecast, and a whopping 19% decline versus consensus 2022. Consensus for 2023 is $232. So, if you want to “take the extreme,” so to speak, the disparity between Wilson’s worst-case profit outlook for next year and consensus is $52 of index-level EPS, or ~22%.
Prices trough before earnings, markets being forward looking and such. So, Wilson’s suggestion that the index will trade down to 3,000-3,300 during the first half is predicated on a trough multiple applied to EPS of $220. By year-end, stocks will be priced off projected 2024 earnings. Given how bad Wilson’s bear case for 2023 profits is, the bear case for 2024 (EPS of $230) actually represents that largest EPS rebound in percentage terms versus his base and bull cases (table below).
In the bear case, the market puts a 15.3x multiple on expected 2024 profits of $230 to get you the 3,500. Wilson’s base case for 2023 profits ($195) is 16% below consensus.
As with most (all) Street year-ahead outlooks, Morgan Stanley’s US equity anchor piece is… well, it’s an anchor. At 57 pages, you could attach it to your yacht and be confident you won’t float away.
Fortunately, Wilson is a very capable writer, and as such was able to convey the general idea in just a few sentences. “In short, we expect a bust before a boom, and it comes down to earnings,” he wrote, adding that (abridged),
Our highest conviction view across the board is that 2023 bottom-up consensus earnings are materially too high. After what’s left of this current tactical rally, we see the S&P 500 discounting the ’23 earnings risk sometime in the first quarter of next year via a ~3,000-3,300 price trough. We think this occurs in advance of the eventual trough in EPS, which is typical for earnings recessions. While we see 2023 as a very challenging year for earnings growth, 2024 should be the opposite — a rebound growth year where positive operating leverage resumes — i.e., the next boom. As such, equities should begin to process that growth reacceleration well in advance, rebounding off a ~3,000-3,300 price trough in Q1 and finishing the year at 3,900 in our base case.
As usual, Wilson’s outlook comes across as eminently rational, and level-headed. That, more so than any bearishness, is his calling card. Or at least that’s how I’ve always read him.
Wilson was, by most accounts, the most prescient sell-side US equities strategist in 2022. Ironically, that’s probably the best reason to doubt his 2023 outlook, if you’re so inclined. I think he’d agree (wholeheartedly, even) that replicating the sort of prescience he displayed on multiple occasions this year would be a Herculean feat.
To lapse briefly into the colloquial, this ain’t easy. Wilson made it look easy in 2022, though. Let’s see if he can do it again.