Yesterday we observed that in a time when even the Fed admits CPI, and its measurement of inflation is no longer satisfactory, or as Yellen put it "a mystery", Morgan Stanley took a page out of the gold bugs' book, and said that "due to the many criticisms and changing methodologies of the consumer price index as a true measure of inflation, we use the price of gold as a very good proxy of the true value of a dollar over long periods of time."
What Morgan Stanley, and specifically its chief equity strategist Michael Wilson, wanted to do, is show the S&P in real terms, i.e., the nominal value divided by the price of gold, to get to an inflation adjusted number. The result was the following:
It showed the relationship for the real S&P 500 going back to the 1920s, and explained as follows:
we think that this chart does an excellent job of illustrating the length and real price damage levied by the three secular bear markets noted above as well as the persistence of the two long and steady secular bull markets from 1942-66 and 1980-2000. We strongly believe that a third secular bull market began in 2011, not 2009.
And yet, the point of the exercise was not to give the impression to Morgan Stanley clients that all is well: quite the contrary, recall that only a few weeks ago, the same Michael Wilson said that this was it for the market for this year as "January marked the top for sentiment, if not prices, for the year."
Instead, what Morgan Stanley hoped to show is that while a cyclical bear market (i.e., a 20% drop from recent highs) is imminent, it is taking place in the context of a still strong secular bull market. The reason for this attempt to goalseek the narrative, is that as the next chart shows, the worst cyclical bear markets all happened during these secular bear markets while the less damaging ones happened in the secular bull markets. Wilson explains further:
On average, the cyclical bear markets that occurred during secular bull markets were down only 25% whereas cyclical bear markets during secular bear markets were down almost 50%, on average.
This as Morgan Stanley warns, "is a massive difference that investors should consider when preparing for the next cyclical bear market", which the investment bank thinks may have already begun with the topping in valuations and sentiment earlier this year, even though we have not yet made the price highs at the index level.
Here, Wilson also makes an interesting observation that even though there has not been a 20% correction in the
S&P 500 since the financial crisis, one can spot two distinct bear markets in recent history when using the MSCI All Country World Index, which reveals a 26% correction in 2011 when both Europe and Japan had a double-dip recession and a 21% correction in 2015-16 during the global recession led by China's hard landing and the collapse in the commodity/industrial and manufacturing complex.
So could we be on the verge of another 20%+ cyclical bear market for the MSCI All Country World Index?
And here we go back to the "bad cop" part of the Morgan Stanley report, in which it writes that "we think the answer is yes, but only after we make one more price high later this year."
More importantly, however, is the bank's prediction that unlike previous occasions, "the S&P 500 is likely to be a more significant driver this time than it was during the 2011 and 2015-16 episodes."
In other words, look for the US stock market to take the brunt of the coming bear market.
But first... another last minute meltup, because Wilson - who appears to have changed his mind - says that he first expects a higher high in most major equity markets later this year: "In the US, we think that the S&P 500 will top between 2950-3000."
What happens then: "the greatest weakness will likely come from the former leaders which include tech, financials and consumer discretionary in the US. US markets should lead in this decline because the earnings comparisons are the most difficult and financial conditions are tightening the most. Therefore, international developed markets should outperform in US dollar terms."
And here we go back to why Morgan Stanley believes it is still a secular bull market, because while a cyclical bear market is coming, it will be far less painful than if it took place in the context of a secular bear:
Finally, we think that this could end up being another unsatisfying bear market in the context of how most think about the end of the cycle. Whenever one invokes the words 'late-cycle' or 'end of the cycle', the natural response is to want to sell everything, especially since memories of the 2008-09 or 2000-02 corrections are still vivid. Instead, we envision a 1-2-year consolidation with 10-20% price swings and concentrated pain in certain sectors that are either overbought, expensive or fundamentally challenged.
Morgan Stanley's conclusion:
"This will not be the wipe-out scenario that some of the perma-bears out there have been warning about for the past eight years."
To this, the permabears have only one response: the only reason the market appears to be in a secular bull cycle, is because central banks have inflated not one, not two, but three consecutive asset bubbles, at a cost of some $250 trillion in global debt, and the only real variable is whether they will be willing - and able - to blow a fourth, and final, asset bubble. If not, no amount of rhetorical goal-seeking will prevent the crash that is coming and that will make the Great Depression seem like a dress rehearsal.