As U.S. equity markets casually melt up to all new highs with each passing day, Morgan Stanley Equity Strategist Michael Wilson, whose 2,550 year-end price target from back in August was just breached in a matter of months, says he’s getting somewhat concerned given Fed tightening, tax cut legislation that looks increasingly unlikely to pass, USD strengthening and extreme levels in pretty much every economic indicator which will make future improvement nearly impossible.
Given that, Wilson says he now sees “a greater risk for a correction than we have seen in a while…”
With the S&P 500 reaching the lower end of our short term price target (2550-75) we put out in August, we think there is a greater risk for a correction than we have seen in a while. If stocks follow the pattern they have been all year, actual earnings season will be a sell the news event and we could have a decent pull back or consolidation. Other things we think warrant concern include the Fed’s balance sheet reduction, uncertainty around Fed Chair nomination, negotiations on tax legislation, and the scope for a counter-trend US dollar rally.
Six weeks ago we went out on a limb with a shorter term target of 2550-75 for the S&P 500 to reach before 3Q earnings season as the market would realize consensus expectations were once again too low. Having breached that lower bound 9 days ago, we believe it is appropriate to respect the pattern we have been witnessing all year for stocks to rally into earnings season and then fade as the numbers actually get reported. Year to date, this has led to a max 3% drawdown which is not worth trying to play when there is still 15-20% upside. However, with less than 10% upside to our target, the risk reward isn’t as attractive to just ignore the potential for such a move. We also think it could be bigger than 3% this time given other factors at work. Specifically, we must acknowledge:
- the Fed is reducing its balance sheet this month for the first time since QE began,
- tax cut legislation is trickier than tax cut promises, the negotiations begin this month
- we are going to get the next Fed Chair nomination later this month which could disrupt financial conditions
- The US Dollar appears to be in the midst of a countertrend rally, and
- given the extremes in leading economic indicators like the purchasing manager surveys, the chance of a peak rate of change looks more likely than not.
Of course, ‘the catch’ is that he also sees any pullback as just another short-lived opportunity to BTFD!
To summarize, we believe the cyclical bull market that began in 2009 is very much intact but we are more confident than ever that we are in the latter stages. As we noted in our initiation, returns are typically very strong at the end and investors cannot afford to miss such moves given the likelihood of lower returns than normal over the next 10 years.
We believe the next month offers a higher likelihood for a 5%+ correction than we have seen since the summer of 2016. With only 1 percent upside to our short term target of 2575 and 5%+ potential downside, this is not the time to be aggressive like it was in August. Rather than a 5%+ correction we could simply trade sideways for a month.
In either case, we will be buyers of that pullback or consolidation as we believe it will set the stage for the next leg higher, toward our 2,700 target on the S&P by 1Q. Our focus remains on small/mid caps, Financials, and late cycle sectors including Energy, Materials, Industrials, and Tech
So, what evidence does Wilson offer up to support his thesis that equity markets will continue to push higher for the foreseeable future? Well, apparently he’s encouraged that, after a shift to value stocks earlier this summer…
…investors have returned to cyclical stocks in a big way since August signaling that “Part II” of the reflation trade has commenced….to summarize, if we understand it correctly, what goes up will necessarily continue to go up.
So, what tangible “fundamental” evidence does Morgan Stanley offer to support their thesis that stocks have a ways to go to the upside? Well, none really…just a relative multiple chart suggesting that a basket of “reflation” equities trades at a P/E discount to “deflation” equities.
The key fundamental drivers of our thesis are still very much in place, allowing these nominal GDP / inflation-levered sectors and styles to lead. Exhibit 5 below shows that the median relative forward P/E for “reflation” vs. “deflation” stocks has re-rated higher over the past two months. The relative multiple of this pair remains depressed since the Financial Crisis which makes sense given the persistent deflationary pressures—we would expect a continuation of the recent re-rating of reflation levered equity valuations higher as deflationary pressures fade and re-flation emerges. As further fundamental support, Exhibit 6 shows that relative earnings revisions breadth for the aforementioned pair also appears to have bottomed.
Of course, in our ETF-driven world it’s probably not surprising that Morgan Stanley chooses to only focus on relative valuations and completely dismisses absolute valuation levels that look increasingly unsustainable…alas, the chart below was also dismissed in 1999 as irrelevant but by 2001 it was suddenly relevant again…
Go to Source
Author: Tyler Durden