By Michael Wilson, Morgan Stanley's head of US equity strategy
In our 2022 year-ahead outlook for US equities, the primary out-of-consensus call centered on valuation. When we published it in mid-November, the price/earnings (P/E) multiple for the S&P 500 was 21.5x, a historical high ex the TMT bubble. However, the median P/E was actually higher than in the late 1990s. Furthermore, we believed at the time that earnings were well above trend and likely to revert over the next several years. If we were right, then valuations looked even more egregious. We argued that P/Es would fall toward 18x in our base case and 17x in our bear case as the Fed responded to 40-year highs in inflation – the “fire” in our scenario – while growth slowed from unsustainable levels – the “ice.”
Fast forward to today, and it’s fair to say we have achieved our de-rating targets, with the S&P 500 now trading at 17x. However, all of the multiple contraction to date has resulted from the Fed’s very aggressive path on tightening and the subsequent rise in 10-year yields. So, while the P/E is now close to our original bear case and our current base case, the equity risk premium (ERP) is very close to where it was in November. In short, we believe the rates market fully reflects the fire part of our narrative. In fact, rates could have overshot to the upside by incorporating more hikes than the Fed may be able to deliver in this cycle, based on the significant damage to financial asset prices and the approaching slowdown that looks much worse than just a few months ago. This sharper downturn stems from the conflict in Ukraine, the Covid-zero policy in China, and the Fed’s action itself, which has led to a significant rise in the cost of capital, including a 65% increase in 30-year fixed mortgage rates.
Turning back to the ERP, it has recently made some upward progress after the nearly inexplicable move to post-financial crisis lows over the past few months. We attribute that overshoot on the downside to Russia’s unexpected invasion of Ukraine and the extension of China’s Covid-zero policy, both of which accelerated the flight to safety by global equity investors and asset allocators. With the S&P 500 viewed as the most defensive and liquid equity market in the world, it attracted flows like a magnet.
But over the last few weeks, it’s become clearer that our ice scenario is now playing out as well. For most of this year we have received strong pushback on our less bullish view on growth, until now. The change is due in part to the events noted above, but the real driver is 1Q earnings season.
- First, while most companies handily beat consensus EPS forecasts, the bar had been lowered during the quarter more than usual.
- Second, the ratio of negative to positive earnings revisions spiked.
- Third, the quality of the earnings deteriorated as incremental operating margins rolled over for many companies and sectors, including many important large-cap technology stocks.
- Finally, 2Q estimates for the S&P 500 came down while full-year estimates were unchanged.
This effectively raises the bar for the second half of the year, which is about the time the economy will be feeling the effects of higher rates and other headwinds.
Needless to say, earnings season raised some eyebrows among investors, and stocks sold off sharply in April – a seasonally strong month for equities. In the last week, P/Es contracted even further but this time due to the sharp rise in the ERP, while Treasury yields fell by less. This combination suggests the market’s focus has shifted to growth concerns – the ice – and quite frankly, it’s what we’ve been waiting for to call an end to this bear market.
Unfortunately, while we think the equity market has adjusted for higher interest rates, we’re just not there yet with the ERP. At 300bp, ERP is well below our year-end 340bp target, and is underestimating earnings risk ahead. The question is will the equity market go ahead and discount the earnings cuts we think are coming or will it require companies to formally cut guidance? Given the pervasive bearishness now and extreme oversold conditions, we could see it play out either way.
The bottom line is that this bear market will not be over until either valuations fall to levels (14-15x) that discount the kind of earnings cuts we envision, or earnings estimates get cut. However, with valuations now more attractive, equity markets so oversold and rates potentially stabilizing below 3%, stocks appear to have begun another material bear market rally. After that, we remain confident that lower prices are still ahead. In S&P 500 terms we think that level is close to 3,400, which is where both valuation and technical support lie.
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