One day after Goldman reiterated its optimistic outlook on the market, stating that traders appear to have over-reacted to the slowdown signs emerging from both the economy and earnings, despite warning that “risks are rising to the downside” and listing various reasons why the bank’s 2,850 year-end price target may not be hit, Morgan Stanley’s far more bearish equity strategist, Mike Wilson, is out with his latest bearish piece, in which he pours cold water on the “cautiously optimistic” views proposed by his Wall Street peers, and reiterated that “rallies should be sold until the liquidity picture improves, valuations compress further or 2019 earnings estimates are reduced.“
Readers will recall, that just one week ago, Wilson warned that his preferred explanation of recent market moves, namely the “rolling bear market” had “unfinished business with the S&P” and two weeks after “the rolling bear market made its latest and loudest statement yet by attacking this bull market’s darlings – Growth stocks, concentrated in the US Technology and Consumer Discretionary sectors” it was going for the overall market itself.
As we further showed, as of two weeks ago, “the rolling bear has now hit virtually every major asset class and the S&P 500 was the final holdout, beating the CPI year to date.”
Fast forward to today, when Wilson writes that the “rolling bear market” continues to make progress – having now focused on the S&P directly – and notes that “there is growing evidence that it is morphing into a proper cyclical bear market in the context of a secular bull.”
According to the Morgan Stanley strategist, “it doesn’t take heavy analysis to recognize this market is now approaching bear territory,” and although the S&P 500 is only down 10% from its highs, “40% of US Stocks and almost every sector have fallen 20% at some point from their 52 week highs.“
As a result, he believes that “the evidence is building and the message from Mr. Market is clear- The consensus outlook for earnings growth is too rosy next year.“
To be sure, market professionals have heard this message loud and clear, and it’s not just the violent market move.
While for the month of October, the S&P 500 is down 8.8% and gave up all of its YTD gains in just 3 weeks, after being up close to 11%, far more importantly for portfolio managers is that these losses were concentrated in the areas of the market where they are most exposed: Tech, Consumer Discretionary, Energy and Industrials; while the best performers were in the generally avoided defensive sectors–Utilities, Staples, and REITs.
While we already know that hedge fund performance in 2018 has been abysmal, this is the latest confirmation of “extreme portfolio pain” leaving most active managers down on the year as well.
Unfortunately for these long-suffering portfolio managers, there is no hope in sight according to Wilson, who writes that the rolling bear market is quickly moving to complete its job with growth stocks (Tech, Health Care and Discretionary) catching up on the downside and “it won’t be over until this gap is completely closed.”
We showed in last week’s note that growth cyclicals, namely Tech and Consumer Discretionary stocks, have seen their forward P/Es correct by only half as much as the S&P 500 Year to Date. That closed a little more last week but there is still another 5-6 percent to go on a relative basis even if the broader market valuation stabilizes.
But wait, there’s more. Because while traders have been hit with various “rolling bear markets”, Wilson is confident that when looking at the broader market, “this rolling bear is quickly turning into a cyclical bear”, highlighting what he showed in the second chart above that nearly half of all the stocks in the MSCI US Equity Index have now fallen at least 20% from their 52 week high. While this isn’t as bad as 2015 or 2011, the last time the S&P fell close to 20%, “the momentum suggests we may be on our way to those levels if things don’t stabilize soon.“
Wilson then shows another was in which the recent drawdown is different from the other corrections we have experienced since 2015, namely that “the 200 day moving average has completely broken for the S&P and most of the sectors and stocks within the S&P 500 are also below their respective 200 day moving averages.”
This tells Morgan Stanley two things:
- The Cyclical Uptrend that began in early 2016 has been broken, and
- The collapse in the breadth of the market suggests this is more fundamentally driven than most market participants and commentators have acknowledged.
It also tells Wilson that he has been right: in lieu of a victory dance, the strategist writes that “this break is overdue and reflects our primary concerns we have discussed all year”, the same one that most market skeptics have highlighted, namely that “the Fed and other central banks have tightening more than the market (and possibly the economy) can handle and company earnings growth is destined to slow significantly next year thanks to the very difficult comparisons, rising operating costs and a temporary return to fiscal austerity by both companies and the government.”
Commenting further, and referencing the chart above, Wilson says that all year he has been most concerned with the shrinking liquidity conditions as the Fed and other central banks have been tightening monetary policy, and while others may be focused on the neutral interest rate (r*) or the shape of the yield curve, “we have focused on the Global Central Bank balance sheets growth.”
From January’s very healthy 15% y/y rate, these balance sheets’ growth has been plummeting and will go negative by January if the Fed, ECB and BOJ do not change course. Historically, whenever this has happened, we ended up with a financial crisis, a recession or both.
And just in case Wilson wasn’t gloomy enough, he writes that while he has not yet modeled an outright earnings recession next year, he does think that the risk of one is “rising significantly.“
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Putting the above together, Wilson repeats that his “bear case target” for this year has always been 2400 – a far cry from Goldman’s 2,850 PT – and assumes a full blown earnings recession next year which is looking more likely.
Meanwhile, with the Fed having to respond to still strong economic data and the desire to remain apolitical, Wilson thinks it could take another 200 S&P points making 2450 a reasonable downside target.
We expect violent rallies along the way but with market liquidity about as bad as we have seen in our careers, trying to capture them will be difficult.
Morgan Stanley’s target also lines up perfect with the 200 WEEK moving average which the bank views as an absolute floor for the S&P at any time during a secular bull market, although if the S&P indeed hits 2,400, expect panic selling to kick in and drag the S&P far lower as every systematic trader bails.
That said, not even Wilson is a permabear and clarifies that its 2400 bear case target should hold throughout this correction which is taking place inside a secular bull market that began in 2011 and this year “represents a cyclical bear within that secular bull.”
We think this cyclical bear is taking the course of a consolidation that will keep the S&P 500 in a wide range of 2400-3000 for up to two years. This was our call back in January and we think there is now ample evidence both technically and fundamentally to support it. Furthermore, our rolling Bear market narrative seems to have captured this outlook quite well.
While the S&P appears to indeed be on its way to 2,400, the only question outstanding is whether the Fed will step in when this support is breached – in line with market expectations of where the “Fed Put” is found…
… or if Powell will let the market slide beyond, and instead of a cyclical bear market in a secular bull, the current correction is exposed as the long-overdue breach of what has always been a secular bear market, that was only delayed by 10 years thanks to $15 trillion in central bank liquidity.
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