In his last Sunday Start article one month ago, Morgan Stanley's chief US equity strategist Michael Wilson argued that the inexorable rise in interest rates from September into the beginning of October put US equities in overvalued territory for the first time since January.
And while overvaluation itself is never a reason for stocks to correct, it did provide fuel for a brutal move lower once it started... as we witnessed last month.
So when the "rolling bear market" trademarked by Wilson finally decided to attack the most crowded – and expensive – areas of growth stocks in October, the pain, as the MS strategist writes in his latest Sunday Start note, "was greater than many investors could have imagined."
Furthermore, while the divergence between growth and value had been well documented, when divergences get this wide, "they gain a momentum that feeds on itself, until it’s over", the MS strategist adds.
So in October, when "the music stopped for previously protected species of growth", value just went down less, and as Wilson writes today, taking another victory lap, the "wet weather" he warned about back in August "arrived later than I expected, but when it did, it took the form of a hurricane."
The delayed hurricane was not just a function of the September spike in rates. While higher long-term interest rates were clearly a fundamental catalyst for the correction in equities, another concern is starting to creep into investors’ minds, according to Wilson:
They’re beginning to question whether margins could be a headwind for earnings growth next year. Last month we highlighted the lofty margin expectations embedded in consensus forecasts for 2019. Rising wages, transportation costs, interest rates, and other inputs are not likely to abate, and we’re skeptical that the majority of companies will be able to pass them along to their customers.
In fact, Morgan Stanley's economists argue that if GDP growth decelerates to 2.4% as many expect it will, there is a good chance that operating margins are down next year, which could equate to a ~1% miss versus consensus. Why is this important for stocks? Because according to Wilson, "every 100bp miss in operating margins relative to consensus represents a 7% hit to EPS for the S&P 500."
And so, with traders concerns about future profit margins and earnings growing - note the recent punishment doled out for stocks that both missed and beat - the little bit of good news as we enter November is that after the last holdouts in US small caps and growth stocks have finally been taken to the woodshed, Wilson believes that "the rolling bear market arguably has finished its work, or at least the heavy lifting."
Still, before he is accused of turning bullish, the equity strategist writes that he has "no illusions that we’re out of the woods yet on the growth slowdown next year and real earnings risk we have written about." He also remain sharply focused on the shrinking liquidity from the Fed’s ongoing balance sheet reduction and the ECB’s tapering of its QE program that began last month.
Of these the global liquidity shrinkage is the biggest concern, because based on Morgan Stanley estimates, by January the combined balance sheets of the Fed, ECB, and BoJ will be contracting on a year-over-year basis, assuming no change in their current plans.
Historically, when the big three’s collective monetary base shrinks, it doesn’t bode well for asset prices, "though after the worst month in 10 years, some of this has been discounted", Wilson notes.
Looking ahead at the rest of the year, Morgan Stanley thinks US stock markets are likely to remain very choppy but in a narrower range. Specifically, "in terms of the S&P 500, the wider range of 2400-3000 we posited at the beginning of the year has likely narrowed to something like 2650-2800 – but with bigger intraday swings and hard-to-anticipate price action."
This aligns with the bank's 2750 base case target for the S&P which it has maintained all year, although with most market participants now playing defense, "there’s less margin for error, which means stops get tighter just as volatility picks up."
This, in turn, usually leads to forced liquidation of longs and covering of shorts at the wrong moments and to Wilson, that’s exactly the kind of price action we’ve seen, which doesn’t instill confidence. Meanwhile, as we noted last week and as Wilson confirms, the powerful rallies on Wednesday and Thursday were led by stocks on the high-short-interest list and other low-quality cyclicals. This fits the value/growth preference we are recommending, but it’s also creating significant portfolio pain, which typically leads to risk-aversion.
In narrative terms, Wilson says this means that "the rolling bear is turning into a chopping bear".
Finally, the Morgan Stanley chief equity strategist picks up on something we first reported over a week ago - namely the death of "buy the dip", in demonstrating how markets changed in 2018 as monetary policy normalizes and peak growth is evident:
Nothing captures this better than our Quantitative Derivatives Strategy team’s observation that the buy-the-dip strategy that performed so well in the QE era is no longer working.
So to summarize Morgan Stanley's "chopping bear" thesis: October was not just a technical sell-off like the one in February, There are now fundamental drivers: higher interest rates, slowing economic growth next year, margin risk, and tighter financial conditions. Combined, "they all add up to investors holding less risk and, without incremental money flows, this new primary downtrend will likely take time to reverse."
Finally, as we discussed earlier today, the usual deus ex that has stepped in during times of stress, a wave of corporate stock buybacks, appears to be fading away...
... which as JPMorgan warned, if this trend of slowing buybacks continues, "the extra boost that US repatriation provided to US equity and bond markets via share buybacks and corporate bond redemptions is largely behind us." As such, where the next leg higher in markets will come from remains the biggest question for investors with less than 2 months left in the year.