It’s no secret that Morgan Stanley’s Mike Wilson suspects consensus is too optimistic on the outlook for corporate profits in America. And it’s no secret that consensus takes its cues from company guidance.
At this point, though, the disconnect between forward estimates and one of Wilson’s leading indicators is so glaring that it calls for an explanation. It’s not just that someone is wrong, it’s that someone is very, very wrong, and if it’s consensus, there’s a long way down.
Spoiler alert: Wilson thinks he’s probably right.
“As noted here many times, the Street is assuming a very strong recovery in profitability [and] this flies directly in the face of our negative operating leverage thesis that is playing out in the data,” he said Monday.
This is a familiar thesis. Operating leverage increases with inflation, ceteris paribus, a dynamic that even corporate management underestimated in 2021. The scope of companies’ pricing power turned out to be quite broad, but as Wilson reiterated, “operating leverage cuts both ways.”
Morgan Stanley continues to believe that virtually everyone — management, investors and company analysts — is underappreciating “how significant the negative operating leverage is going to get before this earnings recession is over.”
Wilson drew a parallel between the bond market’s “questioning of the higher powers” and what he says could be a similar dynamic for equities. The “higher power” for bonds is obviously the Fed. For stocks, the divinities are corporate management.
He mentioned the rapid about-face in market expectations for rate cuts in the back half of 2023, calling attention to the yawning gap between easing bets and the Fed’s new dot plot which, despite being dovishly “unchanged” from the December vintage, nevertheless suggests Fed funds at 5% through year-end. Wilson also mentioned the epic bull steepening in the curve.
“[This is] the first time we can remember the bond market trading this far away from the Fed’s dot plot — i.e., dismissing the higher power’s guidance,” he wrote. “We think this is important because now, in our view, it’s likely to be the stock market’s turn to think for itself, too.”
He returned to the ERP discussion. 2022’s bear market was all about multiple compression. Now, the focus is shifting to growth, and that’s where the problem lies. “While the P/E multiple has compressed by 19% since the bear market began, the ERP is actually lower by 110bps, and very close to the low-end of the last 15 years,” Wilson went on. “In other words, the portion of the P/E multiple related to growth expectations is far from flashing concern.”
That’s potentially problematic, because as you’ve probably noticed, there’s a new reason to be concerned about growth — namely, a banking sector crisis.
The figure suggests the ERP is as much as 200bps too low.
Note Wilson’s chart header. He believes the headwinds to growth are now very difficult to ignore, even for habitually oblivious equities.
“With the events of the past few weeks, we think it’s becoming more obvious that earnings estimates are unrealistic,” Wilson wrote, summing up. “As we have said, most bear markets end with some kind of event that is just too significant to ignore anymore [and] we think recent banking events and the negative knock-on effects they are likely to have on credit availability is a risk that the market must consider now.”
Yikes! And thank you! These comments are timely and especially valuable.
Your reports often serve to check the sense I have about the state of the market and the impulses that drive it. Lately, the questions on the table included, Is the Fed able to wrangle the US economy in today’s context? And, has the economy become too global and too rich to wrangle?
I trust Mike Wilson’s assessment. He is confirming my concerns that what we are seeing is more akin to recessionary pressures that will play out more like a prolonged and traditional downturn.
The jury is still out. I don’t know what we will be seeing in September. But the need for caution is abundantly clear.
I continue to agree completely w MS. But this trade has been like swimming up a waterfall for months. Any reason why it should be satisfying between now and month end eludes me….
Operating leverage, especially when it’s negative (when sales begin to fall, and/or fixed costs rise) is generally overlooked by most observers. Numerous segments of our economy are comprised of firms with OL>5x, negative when sales fall. At five times, OL will cause a 5% decline in profits for every 1% decline in sales. Firms in health care, hospitality, high tech, transportation, utilities, most of the financial sector and others with high fixed cost structures like them, boast OL of 5-10 times. At OL = 10x, a five percent decline in sales will cut profits in half, even for blue chip companies. It’s just math. I try to avoid stocks in these areas as things slow down. Techs are trying to reduce this impact, especially after the CFO has done an illustrative Power Point for the C-Suite crew. But even cutting 10k out of a workforce of 100k won’t have much impact. Operating leverage is the main driver, by far, of strategic change. It’s great when sales are rising but you can’t slow don’t. OL has driven every firm in the airline and railroad industries into bankruptcy at least once, caused huge consolidation in hotels, department stores, and numerous other maturing industries where 70-90% of total costs are fixed.
Mr. Lucky – It sounds like OL is much less than okay for most companies, especially those in which we invest. I’ve invested in banks (BAC & JPM), and large tech companies (like VZ & GLW). But my focus is now on younger companies with good game. I don’t perceive that smaller companies can afford to exercise such leverage because they just want to “make it” and survive from year to year, month to month. Stupid question: Am I mistaken?
If someone (me) had taken Mike Wilson’s warning in August 2022 and gotten out of the S&P they’d still be ahead 6 months later https://heisenbergreport.com/2022/08/29/mike-wilson-never-liked-this-rally-anyway/
(not sure if I’d have gotten into Treasuries but everyone was talking TIPS then and that probably would have been fine)…
Basically I agree that markets are gambling the Fed will rescue them from their own folly of ignoring a new/old world of high interest rates and conservative bank lending.