“Stocks have taken on a different personality” since the end of Q2 earnings season, Morgan Stanley’s Mike Wilson said Monday.
He called last quarter’s results “a ‘sell the news’ event,” noting that the median and average performance following results was the worst in more than a decade, which he said “makes sense given weakening earnings quality and negative YoY growth for many industry groups, coupled with the strong price run-up into mid-July which fostered extended valuations.”
Valuations are still extended, even after a rocky road for stocks over the past two months. 18x (for the S&P) ranks in the 85%ile, Wilson remarked.
Of course, the real problem with valuations is real yields. I talked about that at some length in the latest Weekly+. Deeply negative reals were rocket fuel for equities post-pandemic, and sharply rising reals were gravity in 2022. But stocks defied gravity for most of this year, re-rating despite stubbornly elevated real rates.
“On that score, the real rate/equity return correlation has fallen further into negative territory, signaling that rate moves are an increasingly important determinant of equity performance from a directional standpoint,” Wilson went on.
Indeed, the adverse reaction for stocks to rising yields post-FOMC was actually larger than the regression-implied reaction (figure on the right, above).
Why the outsized sensitivity? Well, you could suggest that stocks summarily ignored rates all year and were thus due for a wakeup call, hence the ostensible overreaction. Or, Wilson wrote, you could argue that “the equity market is beginning to question a ‘higher-for-longer’ backdrop in the context of a macro environment that looks more late-cycle than mid-cycle.”
If he’s right, rising reals look especially onerous. Remember: Equities can stomach higher real yields as long as it’s possible to argue that rate rise is indicative of the market pricing in better growth outcomes. If that’s not the case, then higher rates predicated on “higher-for-longer” posturing from the Fed are a manifestation of tightening into a slowdown.
Wilson used the two figures above to make a simple point: We’re late-cycle. He’s fairly adamant about it.
But it’s not just macro indicators. Equity market internals, Wilson reiterated, likewise support “the notion that we’re in a late-cycle backdrop.”
