Morgan Stanley’s Adam Parker has undergone an epistemological catharsis of sorts in the past year: having called 2013-2015 largely accurately, 2016 threw him for a loop, when he entered the year bullish, only to turn bearish, and then to flip again (along with most other sellsiders) shortly after the Trump victory. Then, going into year end, Parker remained steadfastly optimistic, however much of that appears to have now changed, because, as he admits in his latest research outlook issued early this morning, he has turned decidedly more sour on the market (although he still expects the S&P to close the year at 2,300, same as Goldman), as his “view of the world has materially changed in the last couple of months” following the furious market rally, which has little optimistic upside left.
To wit: “What increasingly optimistic news are we going to start embedding in our earnings outlooks post-inauguration that hasn’t already been contemplated? A number of stocks are up a lot for which we don’t expect much incrementally positive news for at least the next couple of earnings seasons. So to us, it is WHEN, not IF we should fade this recent reflation trade.“
And speaking of the WHEN to fade the reflation trade, Parker provides a tenative answer: “Part of us thinks we should just sell the inauguration. After all, what incrementally positive and exciting outcomes could be produced in the first few weeks after that? We are worried that there is an arrogance in telling people that they should be worried, but to stay bullish for now. We are getting more cautious and are trying to be prudent as the market has materially appreciated.”
Finally, for those worried that the selling may begin sooner (or later), the note concludes by laying out the list of red flags the Morgan Stanley strategist is monitoring for an indication that the “optimistic” upside case is about to be undone.
Below are selected excerpts from Parker’s full note: “Buy the Election and Sell the Inauguration? The 2017 US Equity Portfolio Playbook“
Our view of the world has materially changed in the last couple of months. For the previous several years we had retained an optimistic view of US equities, fueled by a view that there would be low earnings growth and some multiple expansion. Conversely, we now are forecasting material earnings growth, projecting EPS to be 18% higher in 2018 than in 2016.
However, we are assuming modest multiple contraction going forward, and we think a key investment controversy for 2017 will be at what point does the multiple contraction begin to offset the dreams and reality of higher earnings growth.
Why multiple contraction? We have shown with data and, dare we say, demonstrated in practice over the past few years that forecasting the price-to-earnings ratio is challenging. Over the very long term, we know that changes to the perception about growth and rates matter most for investing. But visibility is also important. We can’t help but think that the Republican sweep has created a more uncertain and volatile outlook for the economy and corporate earnings growth. Moreover, it seems likely that the distribution of outcomes from the Fed over the next two years is skewed toward more hawkishness than had been the case only a few short months ago. With more uncertainty and more tightening, we are no longer comfortable forecasting multiple expansion.
There are many other potential risks, including a slowdown in economic growth in China, elections and uncertainty in Europe, a materially stronger dollar, and a big change to the slope and level of US interest rates (i.e., no “rate Goldilocks”). Our base case price target for year-end 2017 is 2300 on the S&P 500, just a couple percent above today’s level, plus the 2% dividend. This doesn’t leave us outright bearish on US equities, as we were, for instance, in 2011, but it does mean that we will continue to try to analyze sentiment and evaluate signposts to call when to fade the reflation rally. With our base case of 2300 equal to 16.2x 2018e S&P 500 EPS of $141.50, we feel a lot of optimism is already baked into our outlook and current market prices.
Sentiment – Is there anyone left to dream bigger? There are so many ways to gauge sentiment, including meeting with investors, surveying and polling them, analyzing hedge fund exposure, ETF flows, futures positioning, assessing recent derivative trades, research click data, among many other sources. In aggregate, our judgment is that the confluence of these metrics is pretty mixed today, and certainly sentiment is no longer negative enough to make a contrarian call, as it was in early February 2016 for example. In the end, one way to view stock investing is the process of buying a little dream today in the hope of selling it to a sucker with a bigger dream later. By our getting less optimistic, all we are really saying is that today’s dreams are no longer that little. Investors are including materially lower tax rates in the base cases of their earnings outlooks.
Economists are projecting higher growth and rates. The President-elect is tweeting victory laps about the market appreciation. Yet, we struggle to see how corporate earnings and the management teams we are assessing could be as proactively enthused. How should CFOs think about what will happen to interest expense deductions? Will there be accelerated depreciation, or R&D credits? How should they think about capital use? What increasingly optimistic news are we going to start embedding in our earnings outlooks post-inauguration that hasn’t already been contemplated? A number of stocks are up a lot for which we don’t expect much incrementally positive news for at least the next couple of earnings seasons. So to us, it is WHEN, not IF we should fade this recent reflation trade.
Fully aware that in a market that makes idiots out of even the smartest people, Parker then hedges by saying that while the market can keep rising well beyond its “sell by” date, he believes that the selling catalyst may be a very prominent one: the Trump inauguration:
“Fade gauge“: It is easy for someone to say that they are increasingly worried about the bigger picture but think things could remain okay for a while. Part of us thinks we should just sell the inauguration. After all, what incrementally positive and exciting outcomes could be produced in the first few weeks after that? We are worried that there is an arrogance in telling people that they should be worried, but to stay bullish for now. We are getting more cautious and are trying to be prudent as the market has materially appreciated.
Finally, with that honest assessment out of the day, this is what the key warning signs watched by Parker:
What are we monitoring? This is by no means an exhaustive list, but our signposts include: any signs of gridlock in Washington on taxes or regulatory reform, changes to the slope and level of the curve, the UST vs. Bund and JGB gaps, tighter financial conditions globally and in the US, material changes to the commodity complex and that component of the reflation thesis, and news about wage inflation during corporate earnings, among other items.
it was not immediately clear what one should do when any/all of these red flags are hit, and the market – which long ago stopped responding to fundamental or even tehnical signals – keeps rising higher.
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