Invest: Is the bear market over? Morgan Stanley says NO

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Here is a fun fact:

  • Stocks are off to a rough start in 2022, with S&P500 currently down more than 10%

And according to Morgan Stanley, this selling isn’t over yet.

Morgan Stanley just expressed concerns that the index may fall at least another 11%, and potentially 19%.

Stocks started 2022 by suffering their worst sell-off since the pandemic-driven crash in February and March 2020. From its January 3 high around 4800, the S&P500 has fallen as much as 13.8%. The rough 4 months have some believing the market has bottomed, or is at least due for a near-term rally.

In April, Fundstrat’s Head of Research Tom Lee said there was a 90% chance stocks had bottomed for the year. RIA Advisors’ CIO Lance Roberts said it was likely stocks rallied in the next month or two.

Well, we all know what actually happened in the next month or two.

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Morgan Stanley’s Chief US Equity Strategies Mike Wilson doesn’t rule out that second scenario of a near-term rally. He does, however, believe that stocks have yet to hit their floor.

We can’t rule anything out in the short-term, but we want to make it clear this bear market rally is far from completed”

Wilson also said stocks continue to face a challenging backdrop: firms face both inflation and slowing growth as the Federal Reserve begins to high interest rates aggressively. He said he expects the S&P500 to fail at least another 11% and potentially another 19% from Wednesday’s close of 4300. The index opened on Monday at 4130.

With inflation so high and earnings growth slowing rapidly, stocks no longer provide the inflation hedge many investors are counting on. Real earnings yield tends to lead real stock returns on a YoY basis by about 6 months. It suggests we have meaningful downside at the index level as investors figure this out.

We think S&P500 has minimum downside to 3800 in the near term and possible as low as 3460, the 200 week moving average if forward 12 month EPS start to fall on margin and/or recession concerns.

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Morgan Stanley also shared two sets of charts that show why he thinks the blue-chip index is heading further downward in the months ahead.

One was that investors are deleveraging themselves because of higher interest rates, meaning lower liquidity levels. Margin levels – or the amount of money investors are borrowing to buy securities – tend to be correlated with S&P500 returns.

margin rates and S&P 500 returns

The other is the relationship between inflation-adjusted earnings yields for the S&P500 and the index’s real returns YoY. With inflation at 8.5% YoY, inflation-adjusted earnings yields are down. That bodes poorly for the S&P500’s real returns, according to history.

inflation and S&P 500 returns

Stock rallied in a big way on Wednesday, jumping more that 3.3% after Fed Chair Jay Powell said the central bank would raise interest rates by 50 basis points – but likely not by more than that at future meetings – and reduce their balance sheet to slow down rising prices. Investors reacted bullishly because the 50 basis point ceiling for future hikes reduced the risk of the central bank sending the economy into a recession quickly.

But the risk that hawkish monetary policy poses to stocks and the economy is still present. On Monday, Guggenheim Partners Global CIO Scott Minerd said he believes demand destruction from restrictive policy is a more serious threat than inflation. Minerd warned that there may already be significant demand destruction happening in areas of the economy, and urged the Fed to move cautiously.

As Greenspan would say, “let’s just take our foot off the accelerator and see what happens.” I think as long as the world is pulling liquidity out of the system, I don’t think that inflation is going to be the problem, it’s going to be the demand destruction.

In addition to inflation’s impact on earnings, slowing growth as a result of tighter policy is part of Wilson’s bearish outlook. He said earnings estimates are still too high for the next 12 months.

1Q may be the last good quarter of earnings as higher costs and increased recession risks weigh on future growth.