Will Mike Wilson’s Rationality Ever Win The Day?

Morgan Stanley’s Mike Wilson remains skeptical of 2023’s US equity rally.

I imagine that won’t come as a surprise to most market participants. Wilson is steadfast in doubting the fundamental underpinnings of this year’s valuation-driven surge, and he reiterated as much on Monday ahead of Nvidia results and Jackson Hole later this week.

When it comes to documenting the reasons for Wilson’s skepticism, it’s a “let me count the ways” kind of deal. Suffice to say there’s not a lot about this rally that Wilson finds compelling. In his latest, he described a market in thrall to momentum and narratives.

“In a world of price momentum, opinions about the fundamentals are often driven by the direction of price [on] the view that markets are ‘all knowing,'” Wilson said, adding that outside of how momentum shapes perceptions of the fundamental outlook, it “often leads asset managers and individuals to chase.”

The conspicuous absence of a recession in 2023 despite bank failures, inverted curves and all manner of other alleged canaries, altered the fundamental backdrop in the minds of many investors and “the price action supported that view,” Wilson wrote. By August, stocks had overshot and prices are “very hard to justify given extended valuations,” in his view.

He cited a veritable cornucopia of ostensible evidence, most of which is familiar. It’s notable that despite the recent pullback, equities are even richer (i.e., less attractive) from a relative perspective than they were headed into this month thanks to the concurrent bond selloff.

“The net result of all these moving pieces is that stocks are actually now more expensive on an Equity Risk Premium basis even though the P/E and S&P 500 are down 6% from July’s highs,” Wilson said. (“All these moving pieces” was a reference to the myriad factors that conspired to push up long-end US yields this month.)

I talked about those dynamics in “Cash, Bonds Or Stocks?” published here+ over the weekend. Long story short, bonds may look like a compelling value proposition and stocks the opposite, but people said the same in January based on many of the same macro arguments. That didn’t turn out well.

Wilson still suspects markets are under-appreciating the scope for negative pricing power. He observed that “the volatility and amplitude of inflation is much greater when one is looking at prices affecting company sales as opposed to the government figures that measure inflation for the economy.” The simple figure below, which plots import and export prices with CPI, illustrates the point.

If you assume the American consumer will falter in the back half of the year, pricing power may deteriorate further leaving companies with “no choice but to increase their discounting to stir demand,” according to Wilson. If that doesn’t work, he warned, management teams could resort to “large inventory writedowns in Q4.”

He went on. And at considerable length. He touched on Nvidia and suggested the 200-day is a good proxy for the “minimum downside” for benchmarks in the current pullback.

“Tactical price support for the S&P 500 and many leading stocks remains below current prices and in some cases well below,” Wilson cautioned.

He called Nvidia’s 2023 performance “justifiable given its uniquely bullish situation,” but emphasized the peril of extrapolation to the broader market, “particularly” in the context of pervasive macro uncertainty and what Morgan Stanley still believes is a late-cycle environment. The bank is also wary of another deterioration in market breadth and pointed to small-caps’ struggles to break convincingly above levels seen in early-February.

The bottom line is that Morgan Stanley’s US equities team thinks August’s “risk off complexion” is likely to stick around “for at least a few more weeks and possibly well into the fall/winter should fundamentals deteriorate.”

As ever, the problem isn’t Wilson’s analysis. Mike’s pretty trenchant. He always makes a good case and I’ve never read a Wilson note that didn’t seem eminently rational. The problem is that unlike Mike, stocks aren’t known for rationality.