How do you know stocks are a little overextended? A good indicator is when even the most bullish sellside analyst on Wall Street, Morgan Stanley's Michael Wilson, whose year-end price target of 2,700 is the highest of all his peers, warns that stocks may see "pullback or consolidation" and that the coming earnings season may be a "sell the news event."
Looking at the recent surge in the S&P, Wilson writes that broad stock index had gotten ahead of itself, reaching the low end of the bank's short term target (2550-75) for the index prior to earnings beginning (it hit 2,552 earlier this morning). He attributed this rush to buy stocks on the "too low" consensus forecast for Q3 EPS:
The consensus bottom-up forecast for 3Q S&P 500 is just 2.6% and appears too low. A strong 1H and a reluctance of corporates to raise guidance meant that mechanically 2H numbers needed to drift lower. With continued strength in economic growth and momentum in our proprietary leading earnings indicator we think companies will once again deliver versus consensus expectations. Look for continued contribution to overall earnings growth from Tech, Energy, and Financials (ex-Insurance). Accounting changes may also bring forward some earnings recognition, further supporting earnings growth. While the market will be focused on earnings over the next few weeks, bigger picture, NTM EPS estimates continue to rise, which should be a bigger driver of the market's direction.
Looking past calendar year 2017, Wilson underscores the departure observed previously in that twelve month forward earnings have continued their upward trend, instead of being dragged sharply lower, "so the upward trend in NTM EPS is an important factor to consider when thinking about the primary direction of the market." Indeed, 2017 and 2018 so far appear different from the past three years, which saw zero EPS growth and the only upside in the S&P was due to multiple expansion, i.e., central bank liquidity. This time may be different... unless of course there is a sharp economic decline, which would lead to - you guessed it - an earnings drop.
As a result, Wilson believes that "stocks correctly recognized this low bar a few weeks ago and rallied sharply into earnings season--a familiar pattern this year"
They also rallied a little too far, and so Wilson says the he "would expect to see a pull back or consolidation as earnings are actually reported--i.e. a sell the news event." But don't worry: the next move is the "next surge" in the S&P "toward the bank's 1Q 2018 target of 2700".
But before that, there are several downside risks stocks have to get over. First, is the potential impact of recent hurricanes on insurers (& financials), which as Goldman noted yesterday, will be a source of Y/Y Earnings decline this quarter:
Here's Morgan Stanley:
Financials has been a source of strength for earnings growth all year long, but for 3Q the sector actually has a negative contribution to overall market earnings growth. Fundamentals trends did not change on a dime. Rather, cat losses for P&C insurance firms related to the hurricanes are a major drag on the sector. Ex-Insurance, Financials are contributing 40+ bps to the earnings growth rate. Growth looks strongest among the banks as cost cutting continues and the rate environment is more supportive. With Insurance, Financials takes ~140 bps off of 3Q y/y EPS growth. This story has not fully played out yet. Our P&C Insurance Analyst, Kai Pan, has noted that not all companies have yet announced loss estimates, sell side analysts may not have yet adusted numbers, and there are substantial uncertainties around any estimates embedded in numbers that have been updated. On a forward looking basis though, major cat losses tend to position insurers well to pass along rate increases, which can be a tail wind for some in the sector assuming normalization of the forward cat losses.
Another potential concerns is what happens after Q4, when comps get harder and the bar to beat jumps substantially higher, however two things could make such comps attainable: a continued USD weakness, and passage of the Trump tax reform which would cut corporate taxes:
Expectations for 4Q and beyond start to look harder to achieve given they are all for double digit growth rates and will be lapping harder comps (Exhibit 8). For example, 4Q17, currently projected around 11%, is lapping a ~4% growth comp in 4Q16. In addition to underlying economic growth, two additional forces can help make these numbers more achievable: the USD and tax reform.
With respect to the USD, the currency did not really have its rapid appreciation until the last quarter of 2016. This means that 4Q17 is where we start comping against the stronger USD. The DXY is down just over 2% on a y/y base but over 8% from the end of the year. The DXY could rise a bit into year end and still be down several percent y/y. We addressed this in July noting that 1) y/y weakness in the DXY tends to correlate with revenue growth and earnings revisions breadth and 2) that our quantitative equity research colleagues estimated that every 1 percent fall y/y in the dollar equates to roughly ½ percentage point of additional forward EPS growth.
A lower corporate tax rate, which is still our base case, will be a boost for earnings. We have estimated that a 25% corporate tax rate would help lift 2018 earnings by about 6%. Increased investment and late cycle activity as a result of tax reform could also help lift organic growth.
If USD and a lower tax rate alone can help add a mid-single digit contribution to earnings growth, it is not unreasonable to think that next year's higher targets are achievable.
Finally, Wilson writes that one additional final factor that may drag equities lower in the near-term, one which Warren Buffett suggested a week or so ago, is tax Loss Selling.
As we head into 4Q, tax loss selling becomes a possible source of technical pressure on some stocks. We screen the S&P 1500 for tax loss selling candidates, looking for stocks that may have been well-liked to start the year and that have seen substantial price declines. Our screening methodology has produced a -2.3% average and -1.6% median return in calendar 4Q over the last 15 years and appears to yield further underperformance than just a screen of stocks with similar price declines. This year, the screen produces a list of 62 stocks.
The screen of stocks most likely to see tax-loss related selling according to MS is shown below.